Category Archives: Macro Commentary

“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way.” Charles Dickens in 1859 “A Tale of Two Cities”

“Will the last person to leave Britain please turn out the lights.“ The Sun Newspaper, 1992 Election

“Britain’s economy is a must avoid….Gilts are resting on a bed of nitroglycerine” Bill Gross – “Mr Bond Market”

“Much has been written about panics and manias… but one thing is certain that at particular times a great deal of stupid people have a great deal of stupid money.” Walter Bagehot, ‘Essay on Edward Gibbon’

In this post I am going to venture into deep waters, discussing several of the macroeconomic headwinds facing the UK and ultimately why I think this is a very large negative for two assets I am trying desperately to limit my exposure to; the Pound Sterling and UK Housing. I will be testing the bounds of my limited circle of competence here as I am not a trained economist but hopefully for everyone’s sake I’ll be able to keep it simple and thankfully many of my sources have already done the hard work!

The UK Economy

The 2000s were a decade of growth for the UK, but that growth was an illusion. It was not borne out of productivity gains or of diligent savings but instead out of rising debt levels. Our seeming prosperity was, and remains, false.

From 1996 to 2010 exports and investments as a share of GDP declined whilst government consumption grew. The UK economy stopped selling things abroad, stymied private sector investment and instead focused on the expansion of its own government sector. As you can see below Public Spending as a percentage of GDP moved up from a trough in 1999 of 37% to today’s level of 46%.

From 1999 to 2009 public spending grew by 53% and public debt rose 73% (before including exceptional costs like the bank bailouts), despite all this spending, an effective stimulus or boost to growth, Real GDP grew only 16%. A painful example of the inefficiency inherent in government directed spending.

The growth that the UK has had over the last 10-15 years has been heavily reliant upon the extension of credit at every level of the economy; household, corporate, financial and government.

If you combine public and private borrowing, the UK has since 2003 borrowed an annual average of 11.2% of GDP, a clearly unsustainable amount. When the government deficit jumped from 2.4% to 11.2% between 2008 and 2009 all the government was doing was filling the void by replacing the private demand for borrowing which had been crushed by the global financial crisis.

Swimming in Debt

The chart below put together by Morgan Stanley serves to highlight the scale of the problem. The entire developed world is mired in debt but we really seem to be leading the pack, partly as a result of our banks failed attempts to take-over the world in the middle of the last decade. As a percentage of GDP our financial sector exposure is vast compared to other nations, even the apparently banking centric Swiss.

“Households took on rising levels of mortgage debt to buy increasingly expensive housing, while by 2008 the debt of nonfinancial companies reached 110 per cent of GDP. Within the financial sector, the accumulation of debt was even greater. By 2007, the UK financial system had become the most highly leveraged of any major economy…” (UK Budget Report, 2011)

Reliance On Ex-Growth Industries or the Public Sector

“Three of the eight largest sectors of the economy – real estate, construction and financial services – have enjoyed huge growth fuelled overwhelmingly by private borrowings. These three sectors alone account for 39% of economic output.

Another three of the ‘big eight’ sectors (accounting for a further 19%) are health, education, and public administration and defence, each of which has grown as public spending has ballooned.” Dr Tim Morgan

In my opinion there are still way too many financial sector jobs. The financial sector not only employs around 1.1m UK workers but they are often some of the best paid and the sector contributes massively to the UK tax take at around 12% of total tax revenue (PWC 2010 report) relative to their being around 5% of the workforce. The sector is shrinking inexorably but at a very slow pace, I see substantial downside risks to property and employment prospects in finance hubs like Edinburgh and London. However, the UK economy as a whole is highly geared to FIRE (Finance, Insurance and Real Estate) jobs so this shrinkage does not bode well.

The chart below shows the extent of the rebalancing on the UK economy that has taken place over the last 20 years with the “FIRE” sectors stealing share from the traditional industries.

Austerity is going to be a struggle given the current backdrop, the economy is already in recession whilst Europe implodes and the US slows dramatically. There is a comparison with Spain which also made commitments to harsh fiscal tightening to maintain the confidence of the bond market. The markets have not responded favourably, punishing the Spanish sovereign yield because they realise that the banks are heavily burdened with housing market losses which will eventually have to be socialised onto the sovereign balance sheet.

How does Financial Repression impact the UK?

“Financial repression includes directed lending to the government by captive domestic audiences (such as pension funds or domestic banks), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks, either explicitly through public ownership of some banks or through heavy ‘moral suasion’.

Financial repression is also sometimes associated with relatively high reserve requirements (or liquidity requirements), securities transaction taxes, prohibition of gold purchases (as in the United States from 1933 to 1974), or the placement of significant amounts of government debt that is non-marketable. A large presence of state-owned or state intervened banks is also common in financially repressed economies. In the current policy discussion, financial repression issues come under the broad umbrella of “macroprudential regulation”, which refers to government efforts to ensure the health of an entire financial system.” Carmen Reinhart

Regulatory changes like Basel require increased capital for non sovereign assets. The effect seems to be that in these times of extremely scarce capital banks are forced to own UK gilts as these are afforded a zero-risk weighting and therefore improve capital adequacy. The interlinkages between banks and sovereigns increase whilst the return on assets for banks is ground down by these low yielding holdings.

Price Discovery

House prices are interesting to me because price discovery is so slow to happen.

If people selling their house aren’t offered what they believe their house is “worth” they just don’t sell and therefore realised prices are always slightly better than the price at which you could sell on any short(ish) time horizon. Because there is no daily quote on property, there is also no volatility which makes property owners feel much more secure than they should. Your house is not subject to a constant bid like the stocks in your portfolio are. You are also not leveraged 10x on your stock portfolio like you might be on your house – something worth thinking about!

A Global House Price Bubble

As the chart below demonstrates the problem of a housing bubble was truly global, however it also shows that in the post bubble world the German and UK markets have not suffered anything like the declines that the other major markets have.

One might argue that part of this is capital flight from the European periphery nations flowing into the closest safe havens. If that were the case then hopefully my analysis above suggests that the UK’s safe haven status is misplaced and furthermore one might consider how permanent that capital is – what happens if the Greek shipping magnates decide in a few years that it’s to repatriate their wealth? Do you know many people who can afford a £8m two bedroom apartment in SW1? If so, do please point them in my direction.

Housing in the UK takes up a world leadingly disproportionate share of our income. Now an Englishman’s home is his castle but this has always been thus so why has the multiple of disposable income doubled since the 30s or 50s when I’m sure our predecessors were just as house proud?

“Comparing a typical dwelling price with per capita personal disposable income. Such a comparison shows a significant mean-reverting tendency) for real estate prices over time for most countries (the UK appears to be an exception here). It provides some important evidence that the US market is at a very low value in relation to income levels (also this is true for Germany and Portugal).” Julian Callow, Barclays Capital

House Price to Earnings Ratio

The house price bubble in the 1970s in the UK was the result of 30% YoY increases but houses still only topped out at 3.8x average income, falling to 2.8x by the end of the mid 70’s. Today real wages are stagnant to declining and the price/income ratio remains elevated at 5x having peaked at 6.5x.

Now clearly there are only two ways for this ratio to mean revert – a sustained increase in wages so that we grow into housing affordability or alternatively a downward adjustment in house prices. Which seems more likely in a recessionary, over-indebted, 8% unemployment economy; a wages boom or a house price fall?

Repossessions – An Inventory Problem

Property market bulls point out that mortgage arrears and house repossessions have peaked at much lower levels than during the crash of the early 1990s.

(Source: FSA Dec 2011 Mortgage Report)

Repossessions and arrears have been less pronounced during this crisis because the economic crash was so much worse than the 1990s downturn. Because UK banks have been in such a fragile state, “extend and pretend” or “ever-greening” have been the tactics du jour. The government and mortgage lenders have gone to huge lengths to stop any tidal wave of repossessions.

According to the FSA, 5-8% of all mortgages are subject to some form of forbearance. This might mean moving to an interest-only mortgage, reducing your monthly payments, taking payment holidays or increasing the term of your mortgage. All of these steps help the borrower stay current and help the bank pretend they don’t own an impaired loan.

These clearly distressed but currently propped up mortgages aren’t included in arrears statistics and so the headline statistics.

Analysts at the FSA examined the payment patterns of these mortgages which are in arrears. Their report showed payments received as a percentage of normal expected payments due were down to 58.3% of the contractual amount.

Around 8.5% of mortgage borrowers in northern regions were in negative equity, where the loan amount exceeds the property value, in Q4 2011, compared with 3.3% in the south. Ratings agency S&P said that borrowers in the north were 30% more likely to be behind in mortgage payments than homeowners in the south.

Interest Only Mortgages

The chart below shows that in 2007 three quarters of interest-only loans taken out had no repayment plan backing them. This is nothing more than a call option on rising house prices. These interest only products just did not exist prior to the housing bubble.

Both parties to the loan are implicitly assuming that the house will at some point be sold for a higher price to pay off the principal. This is Hyman Minsky’s Ponzi finance in action.

MoneyWeek says “These mortgages are a big problem for lenders. They account for 36% of all mortgages outstanding (43% if you include buy-to-let mortgages). During the next ten years, 1.5 million interest-only mortgages with a value of £120bn (10% of all outstanding mortgages) are due to be repaid. How?

Who knows? Some will be backed by sensible repayment plans, but we wouldn’t be surprised if many have to be extended, putting further stress on lenders and borrowers….

The problem with the UK is that the housing market and the banks are two sides of the same coin. If the housing market falls to sensible levels of affordability, then the banks will be in trouble.”

Government policy has been targeted at protecting the banks and not requiring them to realise losses on housing related loans or securities. Because of this the housing market is taking longer to correct. The problem is that precedent suggests this may not work, Japanese banks were allowed to extend and pretend but it turned them into zombie institutions still struggling with the bubble hangover twenty years later. The housing market has been held up by cheap money and lax policy. For reference the Japanese property market is down around 80% since their peak.

Unwilling Lenders – The Banks

“Ongoing economic uncertainties and high unemployment will likely cause many consumers to postpone moving home or buying for the first time, depressing demand for new mortgage loans. On the supply side, unsecured bank debt has fallen increasingly out of favour with investors, and lenders’ pursuit of secured funding alternatives – in the form of RMBS and covered bonds – has triggered a relative renaissance in these sectors.

But the costs of all types of funding remain high, and combined with tougher regulatory capital requirements, this may incentivise many lenders to curb lending or even shrink their balance sheets.” Andrew South, Standard & Poor

If we pretend that the chap above doesn’t work for a ratings agency, his points are quite credible. Banks are looking to quietly and gradually offload their commercial and residential inventory in the hope they don’t flood the market and collapse prices, however they are cumulatively a huge weight of supply which will cap prices for years to come. We have a Mexican Standoff where no banks want to liquidate as it will damage prices and they would rather extend and pretend. However, each bank wants to be the first to liquidate because it knows the liquidations will force prices lower.

With unemployment rising and home values falling, lenders are less willing to provide new credit or refinance existing loans. Last year, £141bn of mortgages were originated compared in the U.K. with £363bn in 2007, according to the Council of Mortgage Lenders.

This all matters of course because without the extension of loans there is no-one to buy property. Rental yields are not yet attractive enough to provide compelling unlevered returns and the average family or FTB must get a mortgage to participate. In a deleveraging balance sheet recession world where financial repression is part of the policy toolkit it is completely rational that banks take the proceeds of loans that are repaid and roll that money into government bonds rather than their mortgage book. This will improve their capital base and risk weighted assets. There is however a fallacy of composition in that what is right for one bank to do becomes a systemic issue if all banks act the same way.

The growth of credit extended to the Private Sector is intuitively a very strong predictor of the changes in house prices in the UK.

Extreme Sensitivity to Interest Rates

Regulators are requiring banks to strengthen their balance sheets and make greater provisions against loans. The effect of this is a creep higher in all funding rates but particularly on standard variable rates which comprise almost 70% of outstanding mortgages in the country.

Low rates have masked the extent of the UK’s problems as they have forestalled consumer deleveraging. Lower rates have postponed and prolonged the emergence of mortgage and consumer loan delinquencies as they remain serviceable and current.

Fixed rate mortgages now equate to only 30% of the mortgage market as banks have shifted the risk of changes in interest rates onto the borrower via variable rates or “trackers”. The average Standard Variable Rate is 75bps higher than the average 2 year fixed mortgage. Using the average outstanding loan value this equates to an increase of £900 per year or almost 25% of UK average real disposable income.

The risk here is huge given the already stretched households.

More worryingly, the SVR spread over base has jumped to 300bps and creeping higher from a pre-crisis average of around 150bps.

Demographics

The great thing about demographics is how predictable they are. We can say with near certainty that we know now how many 40 year olds there will be in 10 years time looking to move from their first home to their main family residence. Unfortunately the demographic pyramid tells us the answer is – quite a lot less than we might need. Now demographics are not destiny but without a major change in immigration policy they allow us a glance at the secular quantum of buyers and sellers in the future.

As the UK ages the demand for housing will decline, the velocity of transactions will decrease as people do most of their moving when they are younger, the under 25s move twice as often as the over 50’s. The eldest segments of the population also require fewer square feet per person than families do. Furthermore, older people are less capable or willing on average of bearing the debt burden of a large mortgage and are unlikely to lever up to buy a house. Although the UK’s demographic time-bomb is not as bad as some other countries like Japan’s or China’s it is considerably worse than the US’s young, dynamic and constantly evolving population. Rather than a middle age spread one would desire a pyramid shape to the chart below.

For each person that moves back into their parental home, or each elderly person that moves in with their children, another unit of excess inventory is created. Despite current record low interest rates most young couples cannot afford the average house – the most logical way for this re-adjust is with lower prices. The average age for a first time buyer in the UK is 35 years old; compared to 31 in the United States. Given the cultural similarities it is fair to assume much of this differential is down to affordability.

Home ownership is waning due to unemployment, inability to meet mortgage standards and a general disdain that is beginning to take root for owning an asset which is no longer guaranteed to appreciate. The fact it’s no longer a certainty to make you rich, a huge mindset shift from a few years ago, may make young people question if home ownership is worth the hassle – rent or stay with your parents instead. A secular shift to a realisation that houses are liabilities and not assets is perhaps afoot.

Unhealthy Growth – Rising Inequality

The gap between rich and poor is greater in the UK today than at any stage in the last 40 years. It is wider in the UK than in three quarters of OECD countries.

The Currency

No-one needs to own Sterling. Our fiscal largesse and austerity mirage would suggest that we have the benefit of being a reserve currency or a global trade currency – we do not.
The currency market will eventually reflect the reality that most of the fiscal austerity of the Conservative government is an elaborate ruse with government spending today £22bn higher than it was in 2008 and only down 1% or so on last year. Given the squanderous starting point this is hardly drachonian.

I believe sterling has benefited from being a comparative safe haven relative to the Euro over the last 24 months. Unfortunately, I think we have more in common with the Italians or Spanish than we do with the Germans.

Conclusion
I believe that we don’t just have an overvalued property market in the UK but that we are also facing many structural, societal and financial problems which does not justify the current premium placed on home ownership that assumes it is a productive asset rather than a liability in which we make a home.

The UK has serious problems with those that will become the property buyers of the next two decades. There is excessive youth unemployment, an oversupply of graduates possessing a skills deficit for real world jobs, an all pervasive entitlement culture and an intergenerational rift where parents appear to have spent their children’s inheritance and priced them out of their future.

Many graduates have been led to believe that because they possess a degree they have a god given right to highly paid, highly engaging employment in the industry of their choice but alas we do not have need for 25,000 Photography graduates each year or the thousands of degrees in Forensics driven by a generation brought up on CSI Miami. Not every graduate in “International Business Studies” is going to end up working as Richard Bransons right hand man.

Ultimately, the generation under 30s seems incapable of affording to buy their parents house having struggled through the Great Recession are stymied with patchy work experience and often substantial student debt that must be addressed before home ownership or saving even considered. A further 5-10 years of painful deleveraging and scarce growth is not going to help ease these painful adjustments to a harsher reality of lowered expectations and bruised egos.

If you have a plan to sell your house then I think you should do it pretty quickly (I sold an investment property last year) and if you are considering buying then you should perhaps consider the timing or whether you buying for profit or as a home.

It wouldn’t surprise me at all to see house prices at the same level they are today in 5-10 years time, the greater question will be whether they merely stagnate or whether we see a fall of anywhere up to 40% allowing the market to clear and buyers to swoop in.

Prozac Nation

Britain ranks 28th in the world for overall quality of its education system – behind Romania and Costa Rica – despite a doubling of spending since 2000.

Only 55 per cent of young people get a C or better in GCSE English.

The number of prescriptions written by NHS Doctors has risen 300% since 1997

“Insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise.” Peter Lynch

“In short, the depression IS the “recovery” process, and the end of the depression heralds the return to normal and to optimum efficiency. The depression, then, far from being an evil scourge, is the necessary and beneficial return of the economy to normal after the distortions imposed by the boom. The boom requires a bust.” Murray Rothbard

Yogi Berra might say that the month was like “déjà vu all over again” as the market plunged after a strong start the year, just as it did in 2010 and 2011. This was the “Third False Dawn” of recovery. Furthermore, the worries remain the same: no self sustaining recovery, continued private sector deleveraging, financial sector balance sheets and of course the intractable European currency crisis. The driver of market returns in the short term will likely be driven by “Volitics” the uncertain interaction of Policy Uncertainty and Volatility.

More to Go?

Paraphrased from John Hussman….“Michael Wilson of Morgan Stanley noted “Make no mistake, institutional investors are all in.” Wilson reported that the monthly rolling beta of mutual funds (their sensitivity to market fluctuations) now exceeds 1.10 and is the highest since the previous record, just before the wicked market plunge in 2011.

Institutions hold their largest “overweight” in high-beta sectors than at any time since the start of data, and long-short funds are also near their most leveraged long positions in history. Of course, mutual fund cash levels also remain at record low levels.”

I have found the contrast between Positioning and Sentiment very interesting over the last few years and here we have another big divergence. Investors are panicked but fully invested. The rock bottom level of sentiment is definitely a short term bullish indicator.

Divergences in Index Performance

The valuation differential between the US indexes and European indexes is becoming quite extreme. The chart below shows roughly a 12% outperformance of the S&P 500 over the MSCI World since Q3 2011.

The currently Cyclically Adjusted Price to Earnings for the S&P 500 is 21.1x in contrast with the UK at 13x and the MSCI Europe at 12x.

Now the question is does the US deserve a 40% premium to the other major developed markets? Some European markets are trading at their 1982 valuation lows, levels from which spectacular future returns were earned. In contrast the US is trading at levels only exceeded at 2 or 3 times in the 130 years of historic data; furthermore each of those times would have been a disastrous time to invest. I am quite confident that on a reasonable time horizon these valuations will meet somewhere in the middle.

I recently attended a course with Andrew Smithers where he summed up this problem of valuation metrics defying gravity for extended periods.

“In the long run stock prices demonstrate negative serial correlation; however in the short run stock prices demonstrate positive serial correlation. The problem is determining at which point the short run becomes the long run.”

My short exposure remains focused on the S&P 500 and the Russell 2000 because I believe these indexes are much more overvalued than their European counterparts and that the emergence of a recession in the US is still perceived as a very unlikely event by the majority of market participants.

The “green shoots” (no mention of them since 2009!) in the US turning to weeds could really be the catalyst for the currently resilient S&P 500 turning lower. Elsewhere, HSBC’s China PMI, the earliest indicator of China’s industrial sector, retreated to 48.7 in May from a final reading of 49.3 in April. It marked the seventh straight month that the index has been below 50. The Euro Zone composite PMI, a combination of the services and manufacturing sectors and seen as a guide to growth, fell to 45.9 this month from April’s 46.7, its lowest reading since June 2009 and its ninth month below the 50-mark that divides growth from contraction. Official data also showed the UK economy shrank more than first thought between January and March, after the deepest fall in construction output in three years, while government spending made the biggest contribution to growth.

“Macro Friday” as some were calling it today was a washout. UK data was absolutely terrible with the UK Purchasing Managers Index posting it’s second sharpest decline in it’s 20 year history. The “new orders” segment was at a near catastrophic 42 down from 49 the month before.

US Non Farm Payrolls came in below the estimates of all 87 Wall Street economists at just 69,000 jobs when we need at least 120,000 to keep the unemployment rate stable.

Will QE 3 or LTRO 2 or a EuroBond Save the Day?

The most important question to answer is; can unprecedented, concerted global monetary policy action repeal the business cycle? Can central banks and politicians conspire to prevent a downturn in the economy? My answer to that would be no, because they have not managed it before. It’s not like the current set of leaders are the first to be extremely averse to a downturn on their watch, these things just happen, growth flows and then it ebbs – it is the natural order of things.

It seems quaint that only a few years ago the concern in Europe was that there would be “contagion” risk resulting from a Greek default. So worried were they that we had almost-daily pronouncements that Greece would not be allowed to default, that there was no need for a Greek default, the developed countries no longer defaulted, etc. Now that Greece has defaulted, the line in the sand is “That was just Greece; no other country will need to default.”

But just in case, European leaders created all sorts of funds, guaranteed joint and severally, to help bail out nations in trouble. First Greece, then Ireland and Portugal. Even with all the money that was raised, it was not enough to prevent a Greek default. And the “new” debt is trading at around 10% of its issue price.

Spain is too big to save and too big to fail. The only way for Spanish debt to remain at 6% is for the ECB to basically buy it (or lend to Spanish banks so they can buy it, or whatever creative new program Draghi and team can think up). When Spain goes the bond market will look to Italy and then to France. The line must be drawn with Spain. The only outfit with a balance sheet big enough that can also do it in a politically acceptable manner is the ECB, and the only way they can do it is with a printing press. I had actually written the first part of this paragraph earlier in the month – on the 31st May the market turned around on rumours of an IMF rescue package for Spain. This is truly absurd, this is exactly the US led (as largest partner in the IMF) bailout of Europe that was categorically ruled out in the past. Another example why ignoring the politicians is the only logical strategy.

From my perspective the market is not yet fully weighing the situation of Spain or Italy becoming more fully embroiled in the currency crisis and/or capital flight via deposits. The Spanish Bond/Bund spread continues to widen.

In Germany, Merkel’s CDU party won 26% of the vote in the North Rhein (Germany’s most populous state) down from 35% in the previous election. Her rivals the Social Democrats got 39% and the Greens got 12%. The Dutch Prime Minister was unable to reach agreement with his government on budget cuts and therefore resigned.

The growing support for extreme parties at either end of the spectrum has been quite predictable. Nothing has been done to address the structural issues in Europe. Painful solutions are postponed and fudged whilst voters refuse to face reality and politicians refuse to speak frankly about the extent of the problems. The time that has been bought by LTRO’s and Quantitative Easing has essentially been wasted.

Gold has really been dull so far in 2012 basically flat to the end of May. Yet despite this the case for gold is stronger than it was at the turn of the year. The Emperor has no clothes. See this quote from Eric Sprott

“The fact remains that here we are, in May 2012, and Greece is right back in the exact same predicament it was in before its March 2012 bailout. Before the bailout, Greece had approximately €368 billion of debt outstanding, and its government bond yields were trading above 35%. On March 9th, the authorities arranged for private investors to forgive more than €100 billion of that debt, and launched a €130 billion rescue package that prompted Nicolas Sarkozy to exclaim that the Greek debt crisis had finally been solved.

Today, a mere two months later, Greece is back up to almost €400 billion in total debt outstanding (more than it had pre-bailout), and its sovereign bond yields are back above 29%. It’s as if the March bailout never happened… and if you remember, that lauded Greek bailout back in March represented the largest sovereign restructuring in history.”

In this context then, with the crisis proving chronic why has the gold price been so frustrating? I think it lies in the difference between the demand for paper gold and the demand for physical gold. Traders are liquidating paper gold in a “Risk OFF” play whilst long term investors are accumulating physical to protect their wealth. The net is a redistribution of the metal but no change in the price. Eric Sprott highlighted that China posted another record Hong Kong gold import number in March of 62.9 tonnes. Gold imports into China have now totaled 135.5 metric tonnes between January and March 2012, representing a 600% increase over the same period last year. These numbers are incredible!

Global central banks have also continued to accumulate physical gold, with the latest reports revealing another 70 tonnes of gold purchases completed in March and April by the central banks of Philippines, Turkey, Mexico, Kazakhstan, Ukraine and Sri Lanka.

Despite all of this gold only represents about 0.15% of global pension fund assets. The large institutional pools just do not have an allocation to this asset class. The total market cap of all precious metal miners is about 2/3rds of Apples.

Gold, gold mining and mining investment or royalty vehicles are a substantial holding in my portfolio at around 14%. These stocks are cheap on almost any measure, but the same could have been said a few months ago at 30% higher prices. One way to look at mining stocks is to compare them to the price of gold itself. See below from Sitka Pacific Capital…

While instructive, this measure doesn’t do you a lot of good if the price of gold is set to drop precipitously. Consider the case of 1980, when gold was experiencing an epic top and the mining stocks seemed to anticipate the lack of sustainability of the move, driving ratio of miners to gold to low levels. That said, the ratio has provided a pretty good clue to what future long-term returns will look like. Consider the following chart from John Hussman:

This final chart is something to get excited about – sentiment towards gold miner is now at 2009 lows. The combination of low valuations and terrible sentiment gets me excited.

Will Defensives Always be Defensive?

Murray Stahl made some very insightful points in his latest quarterly commentary regarding the perceived defensive nature of the Healthcare and Defence industries because of their lack of earnings variability.

They highlight that spending on national defence and spending on healthcare have grown year on year regardless of the state of the broader economy or market. This discretionary spending by global governments, particularly in the developed west has been the tide that has lifted all boats in these industries but there is no guarantee that this will always be the case, especially should governments catch austerity.

US government forecasts show that by 2017 they will be spending $104bn less on defence than they did in 2010. After eight decades of constant increases these are profound changes that long term investors must consider.

I was bound to come across Steven sooner or later because the online investing community is much smaller here in the UK than it is in the US. He does some very sensible work and his website and premium services seem to be attracting interest at quite the rate.

Without further ado….

an introduction

how did you get started in investing? What attracted you to value investing? About how old were you?

I had no real desire to become a professional investor. I started to really enjoy the intellectual aspects of investing and the challenge of being a decision maker under uncertainty.

I was not attracted to value investing as much as I was attracted to whatever works. Initially, being at least as avaricious as your average young finance professional, I was attracted to the hedge fund legends who have made billions from their endeavours.

I was struck by the contrast between these enormously wealthy fund managers and the vast majority of private clients and investors who have struggled to preserve their capital over the last decade.

I was also intrigued by the fact that some people had seen the financial crisis coming and had managed to avoid the 50% decline in the indexes or perhaps even profit from events. It sounds simple but I basically just started reading the opinions of the people who got it right.

My interest in investing was magnified because I inherited some money/equities a few years ago and therefore I had a pot of capital sitting which I could use immediately. Had I not had any money maybe I wouldn’t have been quite so eager.

Your investment philosophy?

What would you describe as your investment philosophy? How has it developed over time? Are you a long term investor? When do you buy? When do you hold? When do you sell?

I would hope that I am pragmatic rather than dogmatic regarding my discipline. Bruce Springsteen once said that “blind faith in anything will get you killed.”

I am a value investor at heart because that is the only approach that makes sense to me, buying something for considerably less than a conservative appraisal of it’s true value.

Traditional finance theory, your university professor, your broker and your average CFA Charterholder would have you believe that as a security declines in price its risk increases; this is because the standard deviation of returns and the volatility of the price movement have increased. I think this is quite clearly codswallop and in fact the risk has decreased because the downside is now lower, presuming the facts have not changed, and the upside in percentage terms has increased!

What would you buy?

I am also particularly attracted to stocks where I see a highly skewed risk/reward dynamic. I like businesses where there are strong balance sheets and “hidden assets” which hopefully can unlock substantial value over time. The strong balance sheet gives me comfort that you will have the time/flexibility to realize that value.

I have a number of what I call “balance sheet investments”, this is based on a pet theory of mine that analysts are overly focused on the income and cash flow statements but omit the balance sheet from rigorous analysis. I suspect this is because of the shorter (1-6 months) horizons of their recommendations, they believe any balance sheet value isn’t likely to be realized in the short term.

Basically, I believe I have a number of companies that are trading at a discount to the value of their assets on their balance sheet or alternatively stocks that look boring on a P/E basis are actually very compelling when you consider the assets you are getting with the business.

There was one thing I noticed when I first migrated from macroeconomic focused research to the writings of investors who buy equities was that the ones who invest in a vacuum.

The “pure stockpickers”, value or growth focused, who believe that timing economic or business cycles is a fool’s errand had one thing in common – they all got killed in 2008.

Even some of the best were down 30-50%. I don’t find that kind of drawdown acceptable, I don’t have the disposition to deal with it and I don’t think most clients do either. The fact is, no matter how rational you are, if you lose 50% of your net worth you are not going to be able to make optimal decisions.

The Global Financial Crisis demonstrated the true value of “Global Macro”. If you think of investing like a boat race then stockpicking is choosing between the boats. Once in every few years a storm comes along with howling winds and high seas which can capsize boats or leave them stranded way off course. Once in every twenty years a tsunami comes and destroys half the boats. To continue the metaphor, these are the kind of times you want to be waiting in the port listening to the weather report.

This is all a very long winded way of me saying that I consider myself a macro aware, value investor with a strict focus on capital preservation. The natural order of things is growth – trees grow, populations grow, people grow, the intrinsic value of investments tend to grow but like you have to make sure you survive the bad times to participate in the growth.

I am still young, only 26 and I have a huge library of books to get through over the next few years – ask me these questions then and I might give you totally different answers. That would be another example of growth being the natural order of things.

When would you sell?

Regarding my time horizon I am agnostic. I hope I hold things for a long time because I hope intrinsic value grows just as fast as the share prices. I know Warren Buffett says you shouldn’t buy something unless you would be happy to hold it for 5 years or the rest of your lifetime, but that’s easy to say when you’re in your 80’s and you are the richest man on the planet!

If your time horizon is long enough this is nonsense. I’m a big believer in capitalism and in creative destruction. Nothing lasts forever. There is no such thing as a permanent competitive advantage.

So basically I would say I am married to no positions and I have no qualms about selling things if they have gone up or gone down. I’ve been involved in 2 stocks I would consider event driven situations this year too – where I have purchased with a distinct near term event in mind which I thought would realize value.

I hope to sell at the top; but hope is not an investment strategy! I can think of 4 situations where I would sell and a 5th lesson learned:

It has moved closer to my estimate of intrinsic value and therefore represents less a less compelling risk/reward payoff

The position has become too big (this is what is known as a high class problem because the stock must have appreciated substantially)

Something material has changed at the company that alters my view

I am selling to switch into something which I believe is trading at a more compelling valuation.

Going into Q4 2011, I had a large weighting to “Old Tech” in the US – Microsoft, Dell, Cisco, Western Digital. I became very nervous about the macro situation and decided that I would exit Cisco and Western Digital because they are quite sensitive to capital spending budgets which are quite cyclical.

I sold both at nice profits and thought this was a prudent risk reduction, both stocks were still cheap and solid balance sheets however. I even said I might revisit ownership at a later date. Well they are both up around 50% and 20% respectively since I sold – more fool me. The lesson I learned from this is that if you own cheap stocks which you like, you have to be willing to ride out your nerves a little.

Your track record?

Well my track record is on my blog but at the moment it’s very short and therefore tells you nothing.

I guess the first time I thought “you know I could be good at this” was when I got into Gold & Silver in late 2009 at $900 and $17 respectively then rode them both all the way up. I sold out of just silver at $42 and $45 before it imploded in the middle of 2011 because the market was developing bubble characteristics – once the chart goes exponential what else can happen but the trend reverse?

I guess my willingness to include assets like gold in my “circle of competence” is another thing that differentiates me from die-hard value investors. I’m far from alone however, value investors like Jean Marie Eveillard, David Einhorn, Sebastian Lyon and Dylan Grice all have substantial gold holdings.

What has been one of your biggest investing mistakes? What have you learned from it?

A mistake I would mention was a very small “speculation” I made in a mining company called Norseman Gold. These companies are not investments, unless you do A LOT of due diligence. Operationally they were just a disaster and kept missing targets and needing to raise cash.

I thought insider ownership would protect me but it didn’t. Thankfully it was a tiny holding and I am now resolved to do much more work on companies before I buy them and probably to limit exposure to direct mining like that. It’s the kind of industry that attracts crooks, a bit like banking!

From the financial crisis we all learned that 95% of the practitioners in the industry are no more skilled at investment than the average client they serve. They are nearly as uninformed, just as emotional, just as reactionary. The fact that investing is an imprecise discipline, an art if you will, has led to it evolving into a petri dish of Charlatanism, bullsh*t and pseudoscience. The most important thing I learned was that the incentives are totally skewed in the industry.

Investment research

How do you typically find ideas and what is your selection process before an idea gets added to your portfolio? What types of questions are on your investing check list?

I could get my ideas from anywhere. I subscribe to maybe a hundred investment/ finance/economics blogs and some research publications where people just like me with a “Go Anywhere” approach or specialists are constantly putting out content with their thoughts or ideas on themes, countries, sectors, stocks etc.

I have no qualms about admitting to “standing on the shoulders of giants” as Isaac Newton might say. I monitor hedge fund filings to see what the best investors in the world have been buying or selling over the last quarter, that’s always very interesting.

The buys show what they like and the sells sometimes show why a stock has been weak. If a big hedge fund is liquidating a position it can really move the price, if they are selling for non-economic reasons, to meet a redemption for example it might be an opportunity.

I read a lot of fund factsheets and commentary to get a handle on what all the best houses are looking at from a macro perspective and how they are letting that influence their stock selection.

Do you use any specific metrics like ROE, P/B, ROC, other when evaluating equities? Which don’t you use?

I like to look at the Piotroski Score and the Greenblatt Magic Formula. There is a lot to be said for these quant screens for idea generation. They have phenomenal track records. It shows the arrogance of most investors that they think they can “add value” to the mechanical processes of these screens which have been so successful. The painful reality is that we probably can’t!

I find it very difficult to look past the evidence that demonstrates that Low P/E and Low P/B stocks consistently outperform higher valued stocks. Therefore my portfolio is full of Low P/E or Low P/CF stocks.

I don’t really like calculations like EV/EBITDA because frankly I’m not bright enough to understand them. I don’t like DCF calculations too much because it reminds me of my CFA exams and because of their sensitivity to the inputs – garbage in, garbage out. It’s a little bit like the Hubble Telescope, move the variables an inch and all of a sudden you are looking at a different galaxy.

From a broader market perspective I keep a keen eye on metrics like the Shiller P/E, Market Cap/GDP and the Q Ratio. These have very poor predictive power in the short term but extremely good predictive power over the course of 5 years or more. To return to my earlier metaphor, this is part of the weather forecast and high valuations here tell you a storm is coming.

Any sector preferences, currently?

Do you invest wherever you see value?

Yes, absolutely. Institutions have become obsessed with specialism and benchmarking and pigeon-holing fund managers. I think being a good investor or allocator of capital is as much a mentality or a state of mind as anything else. The skill set is almost certainly transferable across asset classes and across sectors.

If you have a good manager why constrain him unnecessarily? He is more likely to uncover a true gem if he turns over 10,000 rocks in the global equity market than if he is only allowed to look at only the Dow Jones 30.

I think the real value is most likely to be found in the places where no-one else is looking and that’s what attracts me to smaller companies and to spin-offs.

What company do you find interesting at the moment and why?

Since Dividend Income Investor.com is a dividend focused website and it’s aimed at UK investors I’ll discuss a UK based stock in my portfolio.

JZ Capital Partners ticks a lot of boxes for me. It yields around 2.2% which is good but it’s not why I own it. It’s not covered by the sell side and it’s quite small, about £250m, so most of the large institutional firms can’t own it due to liquidity constraints and the fact they’d have to own half the company to move the needle for them. It’s in listed private equity too so that’s at least another 50% of the potential investors ruled out because this has got to be one of the “ickiest” sectors in the market currently.

JZCP trades at around a 40% discount to NAV which is pretty wide, especially since the two managers have a pretty good track record throughout their career and even over the last few years of profitable investments and realizations.

The thing that got me really excited is when you look at the underlying portfolio of the fund there is about £160m of Gilts and cash, £50m of listed US equities and so you are getting £210m of private equity investments for near free. Given they just sold one stake for $40m in November that seems like a good deal.

Portfolio management

How many positions do you typically have in your portfolio and what are your ideas concerning portfolio composition? Do you follow any key risk-management guidelines in managing your portfolio?

At the moment I have 24 positions and around 30% in cash. I’d say a “full position” is 3% and if I have particular confidence in a position then it would be 5-6% but I would keep the number at that size small.

Berkshire Hathaway (3% position) is a stock that I think is looking pretty cheap currently, with Buffet’s buyback comments last year putting a quasi-floor about 5% below the current price, you could run Berkshire as a 20% position and be able to sleep at night. Nothing is set in stone.

I probably have smaller positions currently than I would under “normal circumstances” because of my particularly pessimistic macro/market view. If I was more bullish and was fully invested the number of positions would be slightly higher but the average position size would be closer to 3%.

Risk is not a number, it is not standard deviation, it is not volatility, although I confess to being more disturbed by volatility than many value investors. Risk is taking risks you don’t know you are taking, risk is having the wrong frame of reference (resources are finite and the Chinese are buying lots of them = Rio Tinto is a bargain at £70); risk is a permanent impairment of your capital due to selling at a loss or material changes in a business you have not foreseen or accounted for.

Who are your top investment heroes?

Which value investors do you admire most and why?

You’ve asked for it now! Let me split them into two types of investors whom I let colour my thinking…I read or watch absolutely everything these guys produce, there are almost certainly a dozen I’m forgetting.

To make it onto my list there are probably two things you have to have done – produce a very good track record over the years and secondly have foreseen the financial crisis. I am deeply skeptical of so many of the elder statesmen of our industry because I believe that many of them surfed a wave of leverage and beta to get to where they are today.

Which book(s) would you recommend an aspiring value investors should read, and why?

Marc Faber once said that if you don’t read for 3 hours a day then you are kidding yourself if you think you are well informed.

Investing is zero-sum, for every buyer there is a seller, someone with the complete opposite point of view and definitively, one of you is wrong. So you have to do a lot of work to make sure that you aren’t the patsy!

These two books provide you with a great insight into the big picture. They suggest that we are in a great delevetaging process and we face at the very least a few more lean years with shorter, sharper business cycles before we can embark on any sustained recovery

These two books are a treasure trove of insights and quotes that distill much of the value investing mindset in easy bite-size chunks. The Montier book has some fantastic data which proves as much as is possible that value investing works under almost any circumstances and on a variety of time horizons. Both books are quite readable and even funny in parts!

If you have actually read and taken in and internalized the contents of these books, all of which are quite readable for the interested investor there is no doubt in my mind you will be light years ahead of the average investor and better prepared to manage your own investments.

Final wise words?

As a private investor your biggest hurdle is finding a wealth advisor who’s interests are aligned with your own. You will be searching a long time if you are looking for a “broker” that will make you rich. After hefty commissions, over time, you will be lucky to keep up with the indexes.

The two options for the private investor are to spend the hundreds of hours it takes to learn how to manage their own money and hope they are good at it. The other is to find a person, firm or fund who’s assets will be invested alongside yours in a way that focuses the mind of the manager and makes sure your interests are in sync.

Your broker will tell you that it is “time in the market and not timing the market” that matters. They will point out that dividend yields are higher than bond yields and that cash isn’t earning anything in the bank. This is nonsense and is an excuse for their own inability to buy low and sell higher. Value is absolute not relative. We should not compare mouldy apples to mouldy oranges.

To quote Seth Klarman, “Why should the immediate opportunity set be the only one considered, when tomorrow’s may well be considerably more fertile than today’s?”

Bearing that in mind, I think that there is no reason to be fully invested at all times. Your cash position is essentially the reciprocal of the quality and breadth of the opportunity set available at the time.

What’s most telling about this video is the gently mocking tone of the CNBC hosts as they completely fail to grasp that Lakshman Achuthan doesn’t make stock market calls and focuses purely on leading indicators not the co-incident or lagging ones that the market has recently been rejoicing over!

If this macro premise is correct then I believe we will enter another round of the Global Risk OFF game. One of the most appealing risk off trades from my perspective is short AUD/USD which is now quoted at a near 30 year high against the greenback. This idea was first brought to my attention by Chris Pavese at Broyhill and I have leaned heavily on their analysis, they have been onto this trend for a while now. Check out their blog at http://www.viewfromtheblueridge.com/

Australian Central Bank has Started Lowering Interest Rates

The Reserve Bank of Australia cut official interest rates by one quarter of a percentage point to 4.50% on the 1st of November. At the same time it also cut its own growth outlook by 50 basis points for the next 12 months to reflect “risks to global growth and heightened financial volatility”. They also highlighted “changes in household spending and borrowing behaviour” which is crucial to the future I envisage.

In January, the Westpac-Melbourne Institute Index of Consumer Sentiment was down 10.7% in annual terms. Ouch!

The index level is still below where it sat just three months ago and prior to two rate cuts of 25 basis points each from the Reserve Bank of Australia (RBA), in November and December. Rate cuts from the RBA typically are a significant boost to consumer sentiment in Australia, given that more than 90 per cent of the country’s mortgages are set at variable rates. But the rate cuts still aren’t working, perhaps the first signs of an Australian household focus on “debt minimisation”?

An economic slowdown in Australia, which would flow from a global slowdown and a weakening of China’s growth rate, will force the RBA to start cutting rates from their current levels which are far in excess of the developed world average.

Although lower rates will help to ease any slowdown in the Aussie economy it will remove one of the key advantages AUD has enjoyed over most other currencies in the last few years – positive carry. If you can borrow money in GBP, USD or JPY at near zero and then invest it in an appreciating AUD earning 4.5% interest then you can cream off that 4% a year without having committed much, if any, capital. It’s a no-brainer, any old mug can do it, and they have!

There is a very strong correlation between foreign ownership of Aussie bonds and the AUD – this makes intuitive sense because people would have to buy the currency to buy the bonds. It seems likely that much of the money has been flowing to AUD because of its safe haven status and its perceived economic invincibility. As sovereigns around the world get downgraded there is a smaller and smaller “AAA Club” and therefore the pools of capital which are forced to own only the highest quality paper are forced to search further and wider. Should this safe haven status ever be called into question, and no-one is sacrosanct anymore, then those currencies most reliant upon capital flows would be the most vulnerable.

Weakening Commodity Demand from China

They call Australia “The Lucky Country” for very good reason. It is surfing the crest of a decade long resource and real estate boom stemming from China’s credit driven demand. Virtually every material that Australia was blessed with has seen enormous price increases over the past decade. Increased demand for Iron Ore, Gold and Coal has been bolstered by massive price increases to boot.

Australia isn’t just lucky though, its symbiotic relationship with Emerging Market demand, particularly Chinese demand, has been the result of a long courtship. Since the mid 1970’s, when colonial ties with Britain were severed, the Australians have naturally sought to do more business with their nearest neighbours. Ironically, what was once a prison island far away for banished convicts is now arguably the most geographically advantageous land mass amongst all the first world nations. China now absorbs far and away the largest share of exports, followed by Japan and South Korea. As you would expect the share of exports to slow or no growth Europe, US and UK is considerably less.

China accounts for 25.3% of Australian exports in 2010. But Australia’s actual export dependency may be great suggest the Interest Rate Observer, Japan get’s 19% and South Korea 9%, both of whom likely take Australian resources, turn them into high tech capital goods and then sell them to China. That’s close to 60% of exports which are highly sensitive to Chinese growth.

This 20 year boom has fundamentally restructured the Australian economy. Over the last 15 years, mining has jumped from 4% to 10% of GDP. At the same time, manufacturing was pared back from 15% to 10%. That enabled the country to more easily absorb the blow when China took over the world’s low end manufacturing industry, which has caused so much damage to industry and employment in the US and here in the UK.

Because of this heavy reliance on commodity exports and mining as a percentage of GDP, Australian markets, including currency, equities, bonds and real estate have become a leveraged play on the growth of the global economy. My own pet theory is that being bullish on Australia is only a little more nuanced and “safe” than being wildly bullish on China, but it’s ultimately the same trade.

When markets are bullish and the Risk ON trade is in full swing, Aussie assets outperform. AUD nearly doubled against the USD since the March 2009 bottom as the world re-embraced risk, global growth and Antipodean decoupling. When markets turn around and go “Risk OFF” the opposite happens – AUD fell by 15% during the last correction.

What no-one is talking about is that most of the Australian economy is possibly already in recession. This is near unthinkable because the world’s 13th largest economy has not had a year of negative GDP growth since 1991! That is astonishing. To quote James Grant

“To applaud a 20 year recession drought is to subscribe to the unlikely proposition that Australia has gone 20 years without overdoing it.”

My opinion now is that only the filter through from the Sino-Demand related industries is keeping the economy humming along. It was a big shock to me when I saw “The number of companies entering some form of insolvency administration in calendar year 2011 continues to set new records” from Dissolve.

Not to worry, there is investment abound from the mining companies planned for years to come. Direct Mining Investment as a share of the economy has gone from 1% to 3% and is heading toward 6% if they hit planned expenditures. This is the highest rate in 100 years.

People discredit the Chinese growth boom as unsustainable due to the predominance of fixed asset investment – the building of roads/buildings/bridges/factories. Often it seems this investment is very wasteful and creates excess capacity just for the sake of GDP growth (Google “Ordos”). Well in 2009 Fixed Asset Investment was 48% of the Chinese economy, in contrast it was only 12% in the US. In 2010, Australia clocked a number of 27.4% according to James Grant – that is China-esque.

Bursting Housing Bubble

“Almost 311,286 properties are for sale across Australia, the highest in more than five years and almost 30 per cent more than the same time last year. In Melbourne, there are 50 per cent more properties for sale, 30 per cent in Sydney, 14 per cent in Brisbane and almost 40 per cent in Adelaide more than this time last year” Perth Now Newspaper article December 1st

Jeremy Grantham is one of the most prescient investors alive today and in 2010 he said

“Australia had an unmistakable housing bubble and that prices would need to come down by 42 per cent to return to the long-term trend. Bubbles have quite a few things in common but housing bubbles have a spectacular thing in common, and that is every one of them is considered unique and different.”

As an example, he cited the British housing market bubble of 1989. At the time, he said people dismissed the bubble because there was no more re-zoning allowed by the councils, creating a land shortage and as such, they believed prices would rise forever. Seven years later they had hit the lowest multiple of family income since the record began in 1945.

There is always some variation of this theme, for example in the US “there isn’t oversupply as the spare houses are in the wrong place”. With Australia it is, “there isn’t enough land in the major cities or on seafront property” and “immigration is creating consistent demand” or “Asian buyers entering the market”. To be fair, Sydney is probably cheaper than Shanghai!

In Australia’s case, Mr Grantham described the housing market as a “time bomb” just waiting for interest rates to rise to levels where prices and mortgages could no longer be supported. In this respect perhaps the rate cut this month will help soften any blow to house prices.

If the Australian housing market did not mean revert to the normal multiple of family income, he said “it will be the first time in history.” This contraction could mean moving from 6x family income down to the current post bubble US levels of nearer 4x – or a price decline of 33% presuming incomes stay flat. What does that do to consumer confidence?

Houses can be bought for relatively low deposits of 5-10% despite what bulls will tell you of conservative lending practices. This article provides some reputable anecdotal evidence of a Real Estate bubble in full swing.

According to Guy Debelle, Assistant Governor of the RBA, low-documentation loans account for almost 10% of new loans and almost half of all new home owners are opting to go for “interest only” mortgages. In other words, they are relying on prices going up.

I think this reaching a point of unsustainability. See the following quote from Prosper Australia.

“There are 1.3 million Australians with negatively geared rental properties. They are diverting all rents and some personal income to meeting interest payment in the hope of capital gains. When only capital losses are expected, investors will flood the market and overwhelm demand.”

This is in the face of interest rates being cut, when even lower rates lead to difficulties meeting mortgage payments the only other options are writedowns or sales.

Steve Keen, Australian economist, shows that Household Debt to GDP in Australia is higher today than it was in the US before the crash.

Chris Pavese said….

“We also find it curious that “investor’s” share of new home loans has risen almost uncontrollably, while first time buyers disappear from the market – a clear indication that affordability is declining, and a big red flag, as first time buyers represent an important link in the housing chain.”

A startling 460,000 households spend more than half of their income on housing costs. It’s no wonder Australian’s are shouting out for help. The cost of housing is the single biggest cost of living issue in Australia today. Steve Keen estimates mortgage interest payments account for an eye watering 65% of after-tax wages. We know from recent experience that the two lines below cannot diverge for long.

In a recent report,Moody’s warned that there are “meaningful uncertainties” for Australian housing and mortgage delinquency rates are likely to increase over the next decade. We doubt it will take that long. “Capital city house prices have more than quadrupled and household debt has tripled since 1990. Simple metrics indicate that the current price levels are not sustainable.”

If a second global recession occurs credit markets will tighten up. Australian banks already have up to 40% exposure to European debt and the big four Australian banks ratings were downgraded by Moody’s Investor service due to this wholesale funding exposure. A recent WSJ article highlighted that the spreads on Commonwealth Bank’s new issues are widening. Unfortunately, in 2011 Australian borrower home loan arrears hit a 15 years high with Australian banks and borrowers in a binge-buying hangover. Mortgages originated at peak prices between 2008 and 2009 combined make up 40 per cent of the mortgage loan books of the major Australian lenders. This equates to slim slivers of equity in many households.

Anthony Doyle of M&G says “The end of a bubble is always difficult to predict and identifying the trigger for such an unwind is similarly fraught with difficulty. Given that markets are extremely sensitive to the potential for asset price bubbles bursting and with the effects of such events still in mind, the Australian housing data are key to AUD maintaining its lofty levels. Something else that is worrisome is that the Australian banking sector dwarfs the size of Australia’s economy at 3.5 times nominal GDP (Ireland’s banking sector was 4.4 times GDP in 2008). The key challenge facing the Australian banking sector is its exposure to the housing market, with about two thirds of assets on the banks books consisting of housing loans.”

Unwinding of Carry Trade/Hot Money

Although Australia has been running large current account deficits for 50 years, the shortfall has been more than made up by large foreign capital inflows for investments or the carry trade. Most recently, China has attempted to take large minority stakes in several firms, especially in the resource area. This will accelerate in coming years to the extent that Australians permit it. A capital shortage in the country there is not, mostly because every man and their dog is rushing to get a piece of the action.

A continuation of home price/currency appreciation at these rates is a mathematical impossibility. Once prices stop going up, the hot money will exit, usually this happens all at once. And like real estate markets everywhere, there is a ton of liquidity on the upside and none on the downside.

Foreign investors bought a record $23.9bn of Australian government bonds in Q3 2011, which takes foreign ownership to 80.4%, which is also a new record high. To quote Anthony Doyle again “this is worrying as heavy foreign ownership of government bonds can be very dangerous, particularly when this is combined with a country running a current account deficit (i.e. the country is reliant on capital inflows from abroad). Ireland and Portugal, which saw similar levels of foreign ownership before the crisis hit, are great (or poor?) examples of how this combination can leave a country’s exchange rate and solvency very exposed if the country hits a crisis.”

AUD has been used as a Risk ON proxy for at least the last 5 years. Movements in AUD/USD are closely related to EM outperformance over the S&P 500. Currently the discrepancy in this correlation is as wide as it has been, the EM/US relative equities have turned down brutally since 2010 and yet AUD/USD remains resilient. I expect AUD/USD to play catch up as people realise this is not a safe haven with a free spread.

US Dollar – How Counterintuitive would it be if we have already had the Dollar Collapse?

The strength of the US economy relative to the rest of the developed world in the last few weeks is likely to help the USD side of this trade. The economic momentum has also likely put off the risk of QE3 discussions for at least a few months and therefore one of the major downside risks to the Dollar has been mitigated.

With rates anchored at zero in the US and therefore no risk of USD weakness due to rate cuts but a ton of “wiggle room” for the RBA to cut and weaken the AUD.

So I think it’s set up as a very skewed risk/reward currently. Could it rally up to $1.10 from today’s $1.04? Probably, but I don’t think that’s likely given the USD momentum. On the downside, we saw $0.60 in the financial crisis, but I think $0.80-$0.90 is a reasonable target if the cracks start to show.

No-One Expects It

Talk to Australians and they are optimistic and upbeat about the future. I have friends that are considering emigrating, and quite a few who already have! To put this into context, the Australian economy is roughly the same size ($1.4 trillion) as the state of Texas – and I don’t know anyone who has ever emigrated there. But no wonder they all go to Australia, the money on offer is absurd, especially when converted back to GBP or USD. Guys in their low to mid 20s can earn $200,000 a year working in oil services, mining or in specialist fields like dentistry or medicine where they have newfound affluent demand.

The money these guys make juices the rest of the economy – by working a “21/9” schedule, which means working for 21 consecutive days at a remote mine, and then getting 9 days off, they arrive back with a wallet full of cash and looking to spend it on partying, clothes, flash cars and nice apartments.

Europe, UK and the US are all currently mired in a Balance Sheet Recession (BSR). A term for the current “rare disease” the global economy is suffering from coined by Richard Koo in his seminal book “The Holy Grail of Macroeconomics” where he provides a blueprint for our current malaise and provides what I think is the most comprehensive solution to date. This is my attempt to use his template, laid out in the book, to look at our world today. I am not an economist, for that I am grateful, but if I’m wrong on anything please do correct me!

The length of time it takes for the various countries to emerge from their BSR will depend on the policy responses enacted in each economic zone. One precedent is provided by the Great Depression where it took 30 years, from 1929 to 1959 before interest rates returned to their average level of the 1920s. These are once in a generation events and we have never had one affecting such a large bloc of Global GDP simultaneously.

“Recessions are typically characterized by inventory cycles — 80% of the decline in GDP is typically due to the de-stocking in the manufacturing sector. Traditional policy stimulus almost always works to absorb the excess by stimulating domestic demand. Depressions often are marked by balance sheet compression and deleveraging: debt elimination, asset liquidation and rising savings rates. When the credit expansion reaches bubble proportions, the distance to the mean is longer and deeper.” David Rosenberg

What is a Balance Sheet Recession?

“To understand the Great Depression was the Holy Grail of Macroeconomics” Ben Bernanke

A Balance Sheet Recession comes to pass when a plunge in asset prices damages private sector balance sheets so badly as to bring about a shift in the mindset and priorities of the asset owners; from profit maximisation to debt minimisation; and from forward looking to backward looking. When the value of assets like equities and real estate falls but the loans used to purchase them remain, borrowers find themselves with a negative net worth and in a struggle to survive.

As with the asset bubbles that precede them, Balance Sheet Recessions are rare and prolonged events. When they do happen, they render useless the standard economic policy responses taught in universities and practiced by Investment Bankers and Central Bankers globally.

In Japan, as today in the US, UK and Europe, we have a situation where many corporate and personal balance sheets are underwater but “core operations” for most companies and families remain reasonably robust – profits are healthy and cash flow/incomes are solid. In this situation, any rational actor will commit themselves to diligently repaying their debt and adding low risk assets to repair their balance sheet as quickly as possible.

A nationwide plunge in asset prices eviscerates the asset side of the balance sheet but leaves the liabilities intact. The entire economy experiences a “fallacy of composition” which means an action that is most appropriate for each individual becomes ruinous if everyone engages in it at once. In this example, we mean repairing balance sheets.

Koo’s example is as follows – a household earns $1,000 and spends $900, saving $100. The $900 spent becomes someone else’s income and circulates in the economy, the $100 goes to a bank where it is then lent out to individuals or corporates which would then spend or invest it, circulating it back into the economy. Therefore spending and savings both continue to circulate – keeping the $1,000 “in play”. If there are no willing borrowers for the $100 then the banks will lower the interest rate they charge until the demand is created.

But in Japan and in the Great Depression, and to some extent now, there is no demand for the $100 despite interest rates at 300 year lows.

The $100 just sits in the bank being neither borrowed nor spent. Only $900 is spent in the economy and the next household receives only that $900 of which it saves 10% to the bank, which again cannot lend that $90 because there is no loan demand so it stays as reserves. The next household receives only $810 in income and so on. This is a deflationary spiral which would serve only to exacerbate falls in asset prices making balance sheets worse rather than better.

Add to this simple model the additional problem of corporates also in balance sheet repair mode and you have an idea of the problem faced. The economy loses demand equivalent to the sum of net household savings and net corporate debt repayment each year.

This is exactly what happened in the Great Depression taking Gross National Product down by almost 50% in 4 years.

According to Koo, the only solution for this problem is for sustained fiscal policy support via direct government borrowing and spending on real projects to keep the economy afloat whilst private sector balance sheets are fully repaired.

How do we know we are in a Balance Sheet Recession?

Private Sector is Paying Down Debt

Monetary Policy is Impotent

Quantitative Easing Doesn’t Work

Silent and Invisible

Debt Rejection Syndrome

1. Private Sector is Paying Down Debt

Now, as in Japan, it was argued by many that the banking sector was primarily responsible for the recession. It is believed that a struggling banking sector is choking off the flow of money to the economy – we see this in politicians jawboning about “forcing banks to lend to businesses so they can invest” and so on.

For a company in need of funds the closest substitute to a bank loan is corporate bond issuance. Any company that wants to borrow but can’t because the “banks won’t lend” should, in theory, be able to issue bonds on the market. So do the numbers bear out this idea that firms have been going to the market for funding? Not really….Good data was hard for me to find as much of it is polluted by huge government issuance and therefore doesn’t reflect private sector demand – but this is what I got.

Global bond issuance totalled $1.8 trillion in the first quarter of 2011, down 4% on the same period in the previous year.

Issuance by non-financial corporations in 2010 overtook that by financial institutions for the first time since financial sector issuance started to grow in the early 1990s. The $925bn issued by non-financial institutions in 2010 was down from $1,080bn in the previous year. Issuance from financial institutions declined more quickly during the year from $1,487bn to $576bn. All shrinking.

This says to me that corporate demand is at best tepid, especially relative to the bumper years in the mid 2000s. What makes this even more remarkable is that this is the face of ZIRP! These companies can borrow for costs so low they couldn’t have dreamt of them just a few years ago, and yet they still can’t be coerced.

It should be noted that even though the balance sheet recession started in 1989, it wasn’t until 1994/5 that the actual borrowing numbers turned negative – therefore the marginally positive numbers we seeing in the BIS numbers are in keeping with the Japanese roadmap.

Another interesting point made by Koo regarding Japan was that if the zombie banks were the problem, then surely the foreign banks who were willing to lend would have been able to swoop in and hoover up market share. They didn’t. This could be extended to today’s recession where we havn’t seen the “healthier” banks like Standard Chartered and HSBC stealing massive share of the personal and corporate lending markets. Maybe the problem isn’t banks not wanting to lend after all!

Neoclassical theory always assumes that the private sector is attempting to maximise profits. Koo’s theory instead imagines that there are certain circumstances, when their balance sheets are so badly damaged by a decline in asset values, private sector companies will respond by giving primacy to debt minimization.

The standard response from most economists to this recession has been to call for more and more monetary easing in the form of Quantiative Easing and lower and lower interest rates. What this diagnosis completely omits to do is consider whether there is in fact any demand for funds from the private sector.

A recession as prolonged and pronounced as the one we are currently in can only be compared with Japan since 1989 and the Great Depression. Unfortunately, the sample size is small because this “condition” is extremely rare.

Japanese companies have spent the last 15 years paying down debt at a time when interest rates are at zero. From the perspective of an IMF economist, Treasury Policy advisor or a investment bank economist, this makes no sense. As loan rates fall, demand for loans is not increasing. This is madness!

If you are profit maximising, as the private sector is always assumed to be, then the only reason you would pay down debt at zero interest rates is if you have no possibility of making a positive return on your investments – if that’s the case, are you a going concern?

What this persistent paying down of debt in the face of their education and economist’s expectations demonstrates is that the private sector no longer has “profit maximisation” as its main goal – now the goal is debt minimisation. It’s a massive, secular swing in mindset.

Loans to private businesses in Europe grew at just a 1.7% rate in November, a plunge from October’s 2.7% and missing expectations of 2.6% by a wide margin. Corporate credit is being turned off. This has happened even as the ECB’s balance sheet has risen from EUR 1.9 trillion to EUR 2.7 trillion in 6 months is truly remarkable.

Reuters said “Loans to private sector firms in the euro zone fell in November while growth in lending to households slowed, European Central Bank data showed on Thursday, adding to the case for an interest rate cut. The drop in funding to companies increased fears that the region faces a looming credit crunch, an issue of growing concern for the ECB as the worsening sovereign crisis makes firms and households increasingly wary about taking on debt, weighing on the economic outlook.

In an attempt to kick-start loan activity, the 17-country bloc’s central bank conducted last week its first-ever three-year funding operation, which saw banks take up almost half a trillion Euros.”

2. Monetary Policy is Impotent

Governments are supposed to manage economies with monetary and fiscal policy but one of the key characteristics of these rare balance sheet recessions is that monetary policy becomes useless. The Bank of Japan kept interest rates at near zero from 1995 to 2005 but yet the economy did not recover and stock markets did not rally.

The reason for this is one of the key assumptions of monetary policy is not applicable in a balance sheet recession. The assumption that the private sector always has willing borrowers that will respond to a change in the price of credit. Lower interest rates and the number of borrowers will increase and economic activity will pick up. When there are no borrowers the bank is powerless.

As explained above, if the mechanism of recycling savings back into the economy is broken then the government must do something to stop the vicious cycle. The government must do the opposite of the private sector, it must borrow and spend/invest the savings that the private sector is no long demanding to use as loans (the $100 in our example.).

Japan has avoided depression like conditions because the government has, on the whole, borrowed and spent what the private sector would not have. When the private sector is paying down debt, only public sector borrowing and spending can prevent a contraction.

When firms and households are minimizing debt the government is the only net borrower left in the economy and therefore the money supply will contract unless fiscal policy is expansionary.

3. Quantitative Easing Doesn’t Work

Because today’s economists are all trained to think the same way, to assume private sector profit maximisation, they assume that if interest rates are low enough then they will borrow and invest. This clearly isn’t happening. In today’s world we keep hearing that corporate balance sheets are awash with cash (no-one ever mentions the liabilities on the other side.) but this is a reflection of fear and uncertainty on the part of company management – they are not investing and they are certainly not borrowing to invest.

“Imagine a patient who takes a drug prescribed by her doctor but does not react as the doctor expected, and more importantly does not get better. When she reports back, he tells her to double the dosage, but this does not help either. So he orders her to take four times, eight times, and finally a hundred times the original dosage. All to no avail. Any normal human being would come to the conclusion that the original diagnosis was wrong and the patients suffered from a different disease.” Page 74

4. Silent & Invisible

No-one wants to talk about a BSR. Those with the closest knowledge of the situation are incentivised to keep quiet about it. Corporate CEOs and indebted households do not want to draw attention to their underwater balance sheets because this might make their situation worse as investors or creditors attempt to call in loans and bring a slow burning situation to a resolution.

On the other side, banks do not want to draw attention to their decimated loan books, their technically insolvent borrowers or mortgages that are in negative equity. If the payments are being met and the borrowers remain cash flow positive then both parties can “mark to make believe” and “extend & pretend”. Of course ZIRP helps ease this process too.

5. Debt Rejection Syndrome

The generation that survived the Depression has a reputation for a life time of debt repudiation. Those who have been indebted and then suffered through years of hard work to repair their balance sheets are left with a revulsion of debt even after their balance sheets have been returned to health. I believe it will take a great deal of time before the Anglo Saxon economies become as comfortable with debt, especially debt used for consumption, as they were in the last few years.

How do we fix The Balance Sheet Recession and why?

“That’s all it takes, really. Pressure, and time.” Red in Shawshank Redemption

Time, low interest rates and not having to mark assets to market help, but the economy needs more support than these things which are usually enough to restore a cyclical recession to growth.

Japan’s Great Recession has given us a roadmap for how a post bubble economy can have a prolonged workout phase and render most policy tools ineffective.

Japanese GDP stayed above bubble peak levels despite plunging corporate demand and a loss of national wealth of around 85% on asset and equity prices.

Here we have to imagine the counter-factual, which is never easy. The fact that GDP grew in the face of such precipitous asset declines may be viewed as a success. Koo says

“In a Hollywood world, the hero is the one who saves hundreds of lives after the crisis has erupted and thousands have died.

But if a wise individual recognizes the danger in advance and successfully acts to avert the calamity, there is no story, no hero and no movie…..Japan successfully avoided economic apocalypse for fifteen years. But from the perspective of the media, which has never grasped the essence of the problem, the government spent 140 trillion yen and nothing happened. So they twisted the story to imply the government wasted the money.”

So Koo is saying it was only because the government engaged in fiscal stimulus to the extent that it did that stopped a collapse in Japan’s GDP and in its standard of living. Imagine if the S&P 500 or FTSE 100 fell 80% from its current level over the next 15 years and the average home price was circa $20,000 – do you think we’d have had positive GDP growth!?

If this is the case, and the Japanese government more or less did a great job, then does that mean that a Japanese scenario is close to our best case scenario too? A scary thought indeed.

In the simplest of terms, the green line, the Government, needs to spend enough/ run a large enough deficit, to offset the surpluses being run by the Corporates (blue line) and the Households (red line). If they do not offset, then the economy will contract.

The problem is a chronic shortage of demand which Government needs to fill for GDP to be sustained at its current level. From this perspective, tax cuts are less effective than direct spending via New Deal-esque projects, because tax cuts are going to be partially saved by the newly conservative private sector. Robert Shiller of Yale has been advocating these “make work” schemes for some time now as a solution to structural unemployment and skill-wastage amongst much of the under utilised labour force in the US.

This theory sits very uncomfortably with me as a right leaning conservative. Koo even goes as far as to suggest that what the money is spent on is less important than the fact that it is being spent! There is no shortage of need however in the developed world. Roads, Schools, technology infrastructure, high speed rail etc could all be upgraded and would enhance our potential productive ability. How about some spending on making the US Energy Independent so they can stop going to war in the Middle East?

Fiscal Policy – The Success of the New Deal

The chart below shows the impact that the New Deal had on the United States when enacted in 1933. Fiscal expenditure increased by 125% which caused a sharp increase in economic activity which brought the unemployment rate crashing down and increased tax revenues. Remarkably, due to the pick up in economic activity, the increased government spending did not increase the budget deficit.

Bizarrely, the economic consensus is that the New Deal did not succeed and that government spending made an insignificant contribution to the recovery from 1933 to 1936 (its interesting in 1937 the minute expenditures were reigned in a little U/E went up, industrial output fell 33% and equity markets fell 50%).

As Koo points out “It is estimated 25 million people were employed directly or indirectly by these (New Deal) projects. To argue that they had no impact on the US GNP seems preposterous.”page 116.

The Confidence Multiplier

Shiller & Akerlof unveiled this concept in their book Animal Spirits.

“We speak of the basic problem as having to do with what we call a “confidence multiplier”, which refers to a sort of social epidemic behaviour. The conventional Keynesian multiplier is supposed to amplify a stimulus package through multiple rounds of expenditure when consumers or businesses automatically spend their extra income. The confidence multiplier works through the effects of the stimulus, and of subsequent rounds of expenditure, on confidence. The latter is more uncertain and context dependent.

These other considerations highlight the difficulties that governments will have in changing this wait-and-see behaviour (current poor sentiment/debt minimisation), and suggest different concerns about just how to structure a stimulus package. Different kinds of stimulus have different effects on confidence, depending on how they are viewed and interpreted by the public. The focus has to get off of “what fraction of this stimulus will be spent” to “how does this stimulus affect confidence”.

Clearly confidence is historically low and therefore the positive feedback loop that economic confidence engenders is weak. I think much of this lack of confidence stems from a lack of certainty – over jobs, housing, tax codes, policy, everything. No-one wants to play if the rules of the game will be changed half way. Provide certainty and we have a base for confidence. I believe a “New Deal” type fiscal package, commitments to sustained low rates and probably some tax code reform including incentives for corporates to repatriate offshore funds would all go a long way to providing certainty and fostering confidence.

How to Finance Hundreds of Billions of Fiscal Stimulus?

The bond vigilantes have probably stopped reading by now and my membership at ZeroHedge has no doubt been rescinded. The US, UK and Europe are low savings nations relative to where the US was in the 30’s and Japan in the 90’s. However, the answer is actually right in front of us. Because the Private Sector is deleveraging the net household savings and corporate debt repayments are not being re-lent to the private sector, they can easily be used to mop up new issuance of bonds from the governments. The government can borrow the $100 left over from our earlier example and spend it instead of the private sector.
Furthermore, the banking sector is also mired in a BSR with capital constraints, they will happily buy government bonds and earn a small spread because it lowers the risk of their balance sheet and requires little capital set aside against it. This has been happening for 18 years in Japan and 3 years in the US, UK and Germany.

Koo adds a further insight….

“The low yields on government debt are also the market’s way of telling the government that if there is anything to be done with taxpayer’s money, now is the time to do it…The market is imploring governments to undertake such projects NOW for the sake of both the economy and taxpayers.” Page 267

Why can’t we have inflation?

Quantitative Easing improves the liquidity sloshing around the banking system, it does not improve the solvency of the institutions.

Look at the chart below showing the effect of Fed QE on the Monetary Base.

This is the inflationary risk and it is huge. However, if there are no borrowers then this “money” sits in the banks as excess reserves and poses no inflationary threat. As long as there are no borrowers, no amount of QE will generate inflation. Unless private sector behaviour and preferences switch back to profit maximisation there will be no inflation.

The banks have no use for these funds, as they cannot lend it to the private sector, and so they must buy bonds issued by the central bank as they are the only willing borrower.

Koo postulates the only inflation the central banks can generate is the obviously undesirable hyperinflation, not moderate inflation.

“Although a central bank can always generate hyperinflation by acting so as to lose the public’s trust, its ability to induce modest inflation depends on whether private businesses are in profit maximisation mode or not.” Page 137

Again, we come back to the chart above, without borrowers of the excess reserves, there can be no credit growth and no inflation.

“The failure of the Bank of Japan’s five year experiment with QE to generate either inflation or growth in the money supply is proof that trust in the central bank remains intact. As long as it does, nothing will happen to inflation, because people have no reason to abandon the correct and responsible course of paying down debt.” Page 137

QE Related Price Boosts

Investors become much more focused on dividends and DCF as a guage of value after a bubble collapse. It seems unlikely that they will view price rises brought about by central bank asset purchases as anything more than transient unless they are certain the price is backed by future cash flows. This means there is not likely to be any inflationary consequences to these asset price increases.

“Central Bank purchases of government debt invariably imply an injection of reserves into the banking system. Even though additional reserves will have no inflationary consequences as long as there is no demand for funds from the private sector, once demand returns, the central bank will face the risk of a massive credit expansion based on excess reserves already present in the system.” Page 138

Central Bank purchases of debt do not create inflation. The resumption of borrowing/spending/investing by a private sector borrowing from a banking sector awash with liquidity does.

Helicopter Money

“Money is distilled work” Little House on the Prairie

Helicopter Money is a cure that is significantly worse than the disease. Because fiat money is no longer backed by gold and instead only by faith in central banks it must be treated carefully. When Bernanke threatens to drop money out of Helicopters he only thinks of the demand side of the equation, people would pick up the money and go spend it. However, he overlooks the fact that any rational shopkeeper upon seeing this would automatically close their stores as they have no way of knowing the value of the money they are receiving. The economy would collapse to barter.

The Differences between today and Japan/Great Depression?

Cultural Differences have nothing to do with the BSR – “The Japanese have a different mentality” is not a relevant argument. It is the nationwide (or global in 2008) collapse in asset prices that wrecks individual and corporate balance sheets that trigger these rare and prolonged slumps.

The US and Japan could export their way out of theirs – we no longer have this luxury. The economic bloc’s currently experiencing the global balance sheet recession are the largest consumers in the world and are too big to viably export their way out of trouble.

Both The Depression and Japan’s Recession were at a time where they were demographically much better placed to recover than the developed world currently is.

We are conducting a live experiment on the patient currently – the US seems to be taking something more akin to Koo’s recommended path, promising austerity tomorrow but remaining accommodative today (extension of unemployment benefits, tax cuts etc). Elsewhere the UK and Europe are going the route of the hard money, Austrian economists and enacting austerity, or at least making plans to enact austerity imminently.

Interestingly, since the two political paths started to diverge, when the Coalition won the election in the UK we can see that the US has started to decouple from its two peers and some are arguing that it will enjoy growth next year as the other two totter on the edge of a recession.

If that is the case, then it’s 1-0 to the Balance Sheet Recession diagnosis.

“Forecasts tell you little about the future but a lot about the forecaster” Warren Buffett

Global Recession

DM Equities Down at least 10% for the Year

ECB Rate Cuts

Income Worship

Australia Loses it’s Shine – AUD plummets

Value of Liquidity Increases

USD up 10%

Real Estate Prices Fall 5%

More Fallen Giants

Obama Loses Election

Pension Problems

In hindsight, making my 2011 predictions was relatively easy because I thought that there was a fairly high likelihood of a bunch of non-consensus events happening which would surprise market participants and make me look quite clever. Because of this, I predicted the seemingly contradictory moves to 2% on the 10 Yr Yield and a Silver price spike to above $40 per ounce (and got out before the crash, with thanks to Cullen Roche at PragCap!).

This year I feel that it’s much harder to be contrarian, the world is distinctly gloomier and furthermore, I am finding it hard to even get a handle on “where consensus is?” I think these predictions are probably more about degree of difference from what many market participants are saying.

In caution, I refer to Bob Farrell’s Market Rule #9 – “When all the experts and forecasts agree — something else is going to happen”

1. Global Recession

The US Economy continues to substantially outperform UK and Europe’s austerity based misery; but it still enters recession barring substantial fiscal policy change. In the aftermath of the global financial crisis, PIMCO identified the forces of deleveraging, re-regulation and deglobalization would actt as restraints on potential economic growth for developed world economies. These are increasingly compounded by strained public sector balance sheets and political forces that tend to polarize rather than unite.

My template is that this is just an extension of the 2008 recession, the return to the spotlight of the ongoing Balance Sheet Recession we have been mired in for 3 years. As Niall Ferguson terms it, we are in a “Slight Depression”. The great worry is that we are very light on policy tools to engender a 2009 style cyclical recovery.

“I think there’s a larger camp that says we’re going to muddle through; we’re going to get slow growth. I would point out that that’s never happened. We never muddle through. A market economy does not want to have a static state. It either accelerates or it decelerates, and these forward looking indicators say decelerate.” Lakshman Achuthan

Achuthan makes a very interesting point here given that “muddle through” has become a very common “go to explanation” for many market commentators. If what he says is correct, and it usually is, then there is great concern to be taken from the pronounced deceleration in most economic activity indicators globally.

HSBC Flash PMI Index

2. Developed Market Equities Negative for the Year

The Street consensus is, as it always is, for a good year in equities with around an 11% increase on the S&P 500 to 1360 (this is exactly the number they had for Year End 2011 too!). In recessions equities get whacked by at least 20%. I say this as fact until someone proves me wrong. I do not care for strategists telling me that recessions are priced in; I strongly suspect that this is absolute nonsense. Markets are incredibly good at whistling idly by until the evidence smacks them in the face.

“When the music is playing, you’ve got to get up and dance. We’re still dancing.” Chuck Prince, Citigroup CEO as of 2007

I think we are probably in a renewed cyclical bear within an ongoing secular bear market.

Andrew Smithers recently updated his CAPE and Q Ratio data to include Q3 earnings reports, at that date the S&P 500 was at 1131 and the market was overvalued by 26.5% according to the Q Ratio, and was overvalued by 37.5% according to CAPE. Historically these valuations are getting close to extremely elevated.

Operating Margins are at near all time highs too leaving much to go wrong, although this partly due to operating efficiencies and productivity gains.

There is the possibility that we have a horrendous trifecta of falling margins, contracting P/E multiples and cyclically enhanced earnings tailing off as the economy rolls over. As I have noted elsewhere, European valuations are considerably less stretched – perhaps with good reason!

However, I believe Mr Market’s way is to attempt to cause the most pain to the most people – in this regard – I postulate if perhaps the most painful trade for the majority of market participants is actually up?

3. European Crisis

The Great Denouement – I don’t believe the can gets kicked into 2013. Austerity leads to slower activity, which requires more austerity, which forces further slowdowns. We are in a death spiral. Every day that the cost of funding is above the GDP growth rate, and this is the case for every single Euro economy as of today, their debt dynamics get worse.

Whichever metrics you look at – absolute bond yields, spreads over Bunds, the TED Spread, financial sector equity and bonds prices, investor sentiment, European PMI numbers etc we can see that the situation is getting out of control. I think markets will force a resolution.

Fate would dictate that the PIIGS have a massive amount of debt rollover in 2012 – more than 300bn Euros from Italy and 100bn from Spain, much of it focused in Q1.

It is also a big year for bank debt rollover, commercial property refinancing and probably financial equity issuance too. Where does all the money come from and at what cost?

The ECB steps up to plate taking rates down further to 0.5%, but only after making politicians sweat for as long as possible forcing bank recaps via nationalisation or rights issues.

I quite like the idea of owning German assets like Bunds for the possibility that in a Euro End-Game scenario they would be converted into Deutsche Marks and therefore receive a substantial appreciation relative to other currencies on that redenomination.

4. Income Worship

There were two main trends playing out in 2011, Risk ON/Risk OFF and the outperformance of dividend stocks. Many investors and professionals embarrassed themselves with doing little more than whipsawing themselves from bullish to bearish based on the most recent press release from the most recent emergency Euro Summit. The market ended flat after months of persistent, record volatility and now investors are watching as many dividend-paying stocks break out to new multi-year highs, regardless of political turmoil here and abroad.

A portfolio of unsexy but high-yielding utilities trounced the market and investors are now paying attention. GMO demonstrated that over the course of 3 years or longer, the dividend stream becomes a larger and larger part of the investor’s total return on an investment. The lesson investors will take away from 2011 is that you can buy and hold, but only if you are being paid handsomely to wait.

Focus on the sustainability of dividends and a requirement of “strong balance sheets” was starting to bore me by Q3 2011 but I strongly suspect it’s only going to get more and more prevalent as the buy on every dip cyclicals disappoint investors. There will be a global dash for finite yield.

I think we’ll see companies forced to give back some of the large cash reserves on their balance sheets as the year progresses. “Use it or lose it!” I expect Tech companies like Cisco, Dell, Microsoft and maybe even Apple to start paying more shareholder friendly dividends.

The only things that don’t work in this space are financial credits and EM bonds. EM bonds in particular strike me as a risky trade because so many big institutional players own around 30% of these relatively immature and shallow markets. Big Boys all trying to fit out through a small fire exit leads to losses for everyone. EM Bonds have also seen a lot of hot money flows from the carry trade and retail investors. Who am I to call out Bill Gross but I don’t think this is a “safe spread”.

5. Australia Loses its Shine

This is a holdover from my 2011 predictions. I think it offers potential as a nice asymmetric trade going into this year. Australia loses its shine as its own consumer debt/housing bubble finally comes to light.House prices as a multiple of income are way too high and given the lack of constraints on land – they are setting themselves up for a fall. Sentiment is resolutely bullish, everyone believes the banks are in great shape, they are perceived to be insulated from the problems in the rest of the developed world. There is a lot of carry trade money that could potentially have to unwind.

To me, they are incredibly sensitive to, and resolutely unprepared for, a slowdown in Chinese growth. I think the housing bubble pops, the Aussie Dollar suffers, rates plummet, the banks hit hard times and the infatuation ends. Their 2012 is our 2008.

Jeremy Grantham is one of the most prescient investors alive today and is arguably the world’s most pre-eminent “bubble spotter”, in 2010 he said

“Australia had an unmistakable housing bubble and that prices would need to come down by 42 per cent to return to the long-term trend. Bubbles have quite a few things in common but housing bubbles have a spectacular thing in common, and that is every one of them is considered unique and different.”

(Charts below from Chris Pavese @ Broyhill)

6. Value of Liquidity Increases

“IF you can keep your head when all about you
Are losing theirs and blaming it on you,
If you can trust yourself when all men doubt you,
But make allowance for their doubting too;
If you can wait and not be tired by waiting……

Yours is the Earth and everything that’s in it,
And – which is more – you’ll be a Man, my son!”

Rudyard Kipling “IF”

You do not make money going into the crisis, you make money in the aftermath picking the flesh from those who were less well prepared. In a crisis, people have to sell positions into illiquid markets for non-economic reasons forcing distressed prices – in this event the purchasing power of your liquidity vastly increases.

7. USD Strength

When all assets are correlated – Cash is King. It’s a safe haven and it’ll be the currency of one of the world’s best performing economies. That alone should be enough to take DXY well into the 80’s or higher. This could be negative for Gold and for other commodities.

I also believe that there is likely a global shortage of USD. Yes, I said it – a shortage of dollars. The total value of Global Credit increased from $40 trillion to $200 trillion over the last decade. That extra $160tn has to either be repaid/retired or defaulted upon. My contention would be that the assets the credit was created to buy are probably underwater. If you borrow $200k to buy a house, you are now forced to liquidate it at $150k; you are short $50k. There is a shortage of $50k that is owed, but is not readily available to the borrower to give back. The “printing” of $2 trillion since 2008 barely scratches the surface of the vast amount of credit dollars created and subsequently vaporised in asset price declines. They should print more and spend it better.

How much further can the global reserve currency of the global economic and military superpower fall when it’s the means of exchange for all major transactions and the unit of account for the world’s best public companies? USD – accepted everywhere.

8. Real Estate Prices fall 5%

House prices are interesting because price discovery is so slow to happen.

If people can’t get what they believe their house is “worth” they just don’t sell and therefore realised prices are always slightly better than the price at which you could sell on any short(ish) time horizon. Because there is no daily quote on your property, there is also no volatility which makes property owners feel much more secure than they should.

For each person be that moves back into their parent’s house, or each elderly person that moves in with their children another unit of excess inventory is created. Despite current record low mortgage rates most young couples cannot afford the average house – the most logical way for this re-adjust is with lower prices.

Home ownership is waning due to unemployment, inability to meet mortgage standards and a general disdain that is beginning to take root for owning an asset which is no longer guaranteed to appreciate. The fact it’s no longer a certainty to make you rich, a huge mindset shift from a few years ago, makes people question if home ownership is worth the hassle – rent or stay with your parents instead.

A secular shift to a realisation that houses are liabilities and not assets is perhaps afoot.

Banks are looking to offload their commercial and residential inventory slowly in the hope they don’t flood the market and collapse prices, however they are a huge weight of supply which will cap prices for years to come.

We have a Mexican Standoff where no banks want to liquidate as it will damage prices and they would rather extend and pretend; however, each bank wants to be the first to liquidate because it knows the liquidations will force prices lower.

To meet the Tier 1 Capital Ratios required by mid 2012, Morgan Stanley estimates total bank deleveraging required over the next 18 months to be somewhere between 1.5-2.5 trillion Euros or alternatively they will need to raise equity in excess of 100bn Euros. The first option could be catastrophic for house prices through asset sales and will prevent all but the safest lending. But it might be the only option because who wants to supply equity to this earnings trend….

9. More Fallen Giants

The Global Financial Crisis and its aftermath saw the embarrassment and the retirement of several investing legends for reasons ranging from exhaustion, poor performance and a loss of fighting spirit. Stan Druckenmiller, Michael Burry and Bill Miller are three of the most prominent.

I predict that 2012 and all the market and macro volatility it will bring will lead to the dethroning of a few more legends. Just look at how John Paulson has fallen from grace in 2011, with his main funds down 30% plus. Top of my “most likely to retire” list are Bruce Berkowitz or Anthony Bolton who are tarnishing their stellar reputations more and more as each day goes by. An extra prediction – Bob Doll of Blackrock, the world’s largest long only equity manager, will be bullish. Thomas Lee of JP Morgan gets fired for being offensively bullish. Crispin Odey, a man I admire very much, runs a risk of decimating his wonderful track record if my predictions are correct. It irks for me to be betting against my heroes.

10. Presidential Election

Who could comment on 2012 without trying to forecast something about the US Election? I would be much, much more interested in this if Chris Christie had been convinced to run for the Republicans. It seems that voters could be faced with a polarized, superficial, simplistic and sound-bite-based choice between President Obama’s pledge to ‘tax millionaires and billionaires’ and protect entitlements, on the one hand, and a fiscally conservative, “big government is bad, entrepreneurs are good” Republican nominee, on the other. According to Betfair, Mitt Romney seems like the most likely opponent for Obama. One would hope that this black or white positioning would encourage the emergence of a credible independent candidate, adding further uncertainty to the election outcome, but it probably won’t.

Things do not seem to be getting better for Joe Six Pack as the Occupy Protests demonstrate. Voter resentment piques at the realization that the Obama Administration promises of “Hope” and “Change” were one of the slickest marketing campaigns in history, but they failed to deliver. Social Cohesion, Income Inequality and Class Warfare continue to be huge issues.

11. Pension Problems & Savings Rates

One of the great unmentionables (we’ll deal with that later) is how vastly underfunded our pensions are – both private and public sector pensions are billions in the red. I think renewed recession and lower asset values make people finally take notice of this sword of Damocles. To make matters worse we are facing lower asset returns going forward across all asset classes and an industry of “expert consultants” are guiding pension trustees towards lower returning, “uncorrelated” asset classes like hedge funds, EM bonds and commodities.

This chart encapsulates the problem…

A balanced, mixed asset portfolio today yields around 3% which is about half of what it did 20 years ago.

Most discount rates I have seen on pension funds are around 8%, the more conservative are around 6% – these are based on backward looking data which use historical returns to forecast future returns. Hello!? It’s not gonna happen!

If you own 10 Year Bonds today you’re getting paid 2%, that means the other 60% of your 60/40 portfolio needs to compound at 14% (after fees, trading costs and taxes) just for you to hit your discount rate – that doesn’t even remotely address the initial underfunding.

Any “Financial Repression” that changes laws to make pension funds and banks hold more Treasuries/Gilts will only exacerbate this return shortfall problem, and on a long enough horizon, probably guarantee some capital losses too.

This is one of the most pernicious consequences of a zero interest rate policy, savers and pensions get killed to bail out people who took too much risk or bought things they couldn’t afford.

I think the long term savings rate has to gravitate back towards 10% and this will be a drag on what percentage of income can be afforded in mortgage payments/consumer spending.

The fact that savings rates started to tick back down again by mid 2009 shows me that the DM consumer doesn’t quite “get it” yet and still believes in a seemingly endless entitlement to both credit and consumption. Perhaps much of the household pain is still to be felt?

I think 2012 will provide massive opportunities for savvy investors to pick amongst “risks worth taking” and will be another year where passive management just doesn’t get it done.

“The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.”
Rudiger Dornbusch, MIT economist

What was previously unthinkable becomes possible, and then probable, with surprising rapidity.

Apparently, when you are in a serious road traffic accident everything slows down and events seem to happen in slow motion; but despite this, you are incapable of acting fast enough, or judiciously enough, to avert disaster.

This is kind of how the economy feels to me right now – we are in a slow motion wreck, each day moving more tortuously towards the brink. But because it’s all happening at glacial speed, every day the market doesn’t decline you have 24 hours and incessant media coverage urging you to second guess yourself.

Take the pulse of the economy and the credit markets with some of the charts in this post…then compare it to the jittery but relatively benign equity markets……One of them is likely wrong.

Do not think that equity performance in October is a non-conforming data point, precisely the opposite. Rallies of the order of magnitude we saw last month are historically associated with counter-trend rallies in a bear market. The Dow had its 3rd best month in 115 years; the two better months were both during the Great Depression. Let’s not get ahead of ourselves….

The economy grew at a 2.5% rate in Q3, so what? In Q2 2008 it grew at 3.3% – this is rear view mirror investing. We need to look at leading indicators, because they are actually predictive, and through that prism, the picture is far from pretty.

Variant Perception

Let me have a go at estimating where the consensus is; from there an investor can decide if he has a variant perception and attempt to express a profitable contrary view.

Mr Market is saying….

– The US economy is showing good signs of stabilisation with incremental data containing “positive surprises”.

– Weakness in Asia will be offset by a policy response from politicians and central bankers who have much more wiggle room than their western counterparts.

– A European recession will be shallow rather than endemic, with eurozone policy action becoming increasingly concerted. A Euro recession is already fully discounted in the regions equities.

– Equities are cheap relative to 2012 earnings and relative to cash and bonds which trade on P/Es of 50 and 30 respectively. Large Cap Quality & Income is the safest place to be in inflation or deflation.

Don’t mention a banking or currency crisis.

For me, the slowdown is global. I still think we’ll have recessions in the US, Europe and the UK within the next few quarters. Not that this really matters as the economy has not actually recovered from the initial debt collapse of 2008, we just dosed ourselves up for a while. We can’t see the forest for the trees.

As Mohammad El Erian said last week, “The big exposure to Americans is the general exposure to the equity market. You cannot be a good house in a bad neighborhood, that’s just a fact. The equity market is the house, and the global economy is the neighborhood. So if the global economy takes a leg down, the equity market is going to take a leg down too.”

As the ECRI head Lakshman Achuthan put it, the decline in economic activity is “pronounced and pervasive” and they see “contagion amongst the leading indicators”.

Now, what I find most instructive about this video is the mocking tone of the CNBC presenters. Here is a man who has a near perfect forecasting record, primarily because he doesn’t make a call until he is extremely confident in its accuracy. Despite this, Steve Leisman mocks him with analogies to “cauldrons” and “witches brews”, consistently interrupting and haranguing him in a way that disrupts his getting his message across. Compare and contrast with the sombre reverence that Nouriel Roubini or Robert Prechter may have received in Q3 and Q4 of 2008. Consider also the unflustered response of the ECRI head – he definitely seems like a man who is sure he will have the last laugh. We’re not ready to hear his message yet.

Europe

The source of my car crash analogy is the ever insightful Mohammed El-Erian; he has a fantastic analogy for the current market climate.

Market participants are in the backseat of a car which is being driven by policy makers. Looking into the front seat we see that the policymakers are bickering between themselves, they are unsure of where they are going or even which map (fiscal or monetary) they should be using. Furthermore, we can see that they do not have their eyes completely on the road despite the all enveloping fog outside clouding visibility; they are looking at each other and they are looking into the backseat asking market participants “How am I doing?”. This metaphor encapsulates some of the confusion and fear that our journey involves.

New sovereign names are being dragged into the fold as the Euro collapses in unison. The only 2 countries not currently (yet?) experiencing their own mini credit crisis are Germany and the Netherlands, not surprisingly the economic zone’s 2 creditor nations. It is a fact that these 2 countries are not of sufficient size to deal with the problems of the rest. The centre can only hold and support the rest if it is of sufficient scale and possesses sufficient will – both are in question. When Europe’s slow motion crisis began in Q4 2009 commentators were comfortable that the PIGS could be supported by a coalition of Germany, France and Italy. Now we are hearing that Germany and France can support the PIIGS, despite the newly involved Italian bond market being the third biggest in the world.

Well……look at the French yields, in a matter of days France could be in the dangerzone too. An aside on that note, what on earth was that bond downgrade story which was released and then pulled in quick succession? It seems like just a matter of time…..

A Key Metric is the yield differential between the French and German bonds. French interest rates on its 10yr bond rose to 3.72% this week. That is about 1.9% over German bonds. Just a few years ago that difference was less than 20 basis points. That is the market clearly indicating concern about French debt.

But yet policymakers do not yet seem to comprehend the gravity of the situation as shown by continued attempts at point scoring across the aisles, the call for the Greek referendum by Papandreou and Sarkozy lashing out at anyone who expresses exasperation. Policymakers and central bankers have a problem – they have been trained all their lives to think they can solve everything and that no problem is beyond rescue. They underestimate market forces every single time.

Chris Pavese at Broyhill Asset Management said the following…

“The current condition (in Europe) has all the elements of the classic “prisoner’s dilemma” where there is temptation for each party to deviate from agreement at every step of the way, even if it ends up being extremely counterproductive to everyone. The evidence speaks for itself – approaching two dozen “Summits” over the past two years and we are no closer to resolving the problem of too much debt, with more debt. Instead, we are a lot closer to the end of the European Union as we know it. European policymakers may still prevent a disorderly sovereign default with a “grand and comprehensive” solution, but they cannot prevent the recession which is already in progress.”

The crisis entered a new phase of acuteness in late October as evidenced by the charts below.

From Jonathon Tepper…

“One of the main reasons for the disparity is that Libor panel CDSs, i.e. the credit default swaps on the banks that participate in the interbank lending market, have shot up to levels beyond what was seen during the Lehman crisis. The CDSs are telling you that people have grave doubts about the solvency of the interbank lending market.”

Marcellus:
“Something is rotten in the state of Denmark.”

Horatio:
“Heaven will direct it.

Hamlet Act 1, Scene 4

If only the problem was just Denmark……However, it seems Horatio may have been re-incarnated as a French Policy Advisor.

In short, bankrupt governments are doing everything in their power to keep bankrupt banks on life support, while bankrupt banks try to prop up bankrupt governments. This reminds me of Herbert Stein’s law – “If something cannot go on, it will not go on.”

Bond Issuance

Who is going to buy all these bonds!?

Italy has 220bn Euros of bond issuance planned for 2012, the financial sector is going to need 400bn plus, the EFSF will need to issue lord knows what in lord knows what format.

The EFSF struggled to get away just a 3bn Euro auction a week or so ago! The whole premise is that they will be able to fund the EFSF at low rates but the market doesn’t seem to want to swallow it. The rates paid on the tiny issuances so far are clearly higher than expected and most worryingly, trending upwards!

If investors are unwilling to buy bonds from these governments today, who will buy EFSF bonds backed by the same governments when they have already been judged un-creditworthy?

Everyone has had a pop at the EFSF for it’s many flaws but one of the best was Chris Rice from Cazenove’s attempt…

Some of the details are utterly bizarre….But perhaps most bizarre of all is the EFSF itself. Asking foreign governments, such as the Chinese, not as rich as those of the eurozone, to invest in a vehicle in which they will bear the losses the Europeans don’t wish to bear is quite frankly a joke. My suspicion is that it will never get off the ground.”

The (Temporary) Resolution

Quantitative Easing. The Germans are driving the car, they have reached a fork in the road where they must decide between their hard money principles (a Euro Break Up) or their commitment to the Euro (Fiscal Union). I think that they will opt to protect the latter and print a lot of money, which will of course cure all ills. Of course. No unintended consequences because central bankers plan for every outcome. QE, along with valuations, is probably reason enough to be bullish on EuroZone equities and I will cover that in a future post. At this moment I’m “minimum bullish” Euro equities.

As John Mauldin summarized wonderfully…

“Europe has too much sovereign debt, which is on the books of its banks, which have too much debt; and there is a huge trade imbalance between core and peripheral Europe. All three problems must be solved in order to prevent the Eurozone from imploding. And while the debt is the “sore thumb” today, the trade imbalance is the biggest problem. As I outlined in Endgame, it is impossible for a country to balance its government and business deficits while running a trade deficit. This is an accounting identity and is true for all countries at all times. Greece and others are in a monster predicament. No amount of austerity will work until their labor costs drop (for both private and government workers) and their trade deficits are brought into alignment.

I pointed out that the Eurozone must find at least €3 trillion (give or take) to pay for the sovereign debt “haircuts” and bank losses. Some argue it is only €2 trillion and others argue for €6 trillion. Whatever it is, it is such a large number that it cannot be found by borrowing or creating a special fund. The ONLY way to deal with it is to allow the ECB to print, essentially putting a floor underneath Eurozone bonds, especially those of Italy and Spain, both of which governments are too big to save by conventional means.”

Portfolio Positioning for this – Long Gold, Short EUR/Long USD, tentatively long European Equities (currency hedged) and higher cash balances.

For me, one of the largest red flags in the market has been the continued poor health of the Financials. The reason, of course, is that they are struggling to shrink their balance sheets, “extend and pretend” on their loan books and earn their way out of impending Japanization. I’m not sure where I got this little piece of wisdom from (and if you can prove it wrong please let me know); There has never been a bull market in history that hasn’t been lead by financial stocks. A sobering thought.

Banks are, despite all their crimes, still the veins and arteries that pump credit around the body of the economy which acts as a lifeblood to economic activity.

It seems easy to say as someone who entered the industry in 2008 but I can’t understand why people want to bother with financials. Buffett says he puts Technology stocks in the “Too Hard Pile”, well given that banking is no longer a “3-6-3” Game (take deposits at 3%, lend at 6%, be on the Golf Course by 3pm), I think banks fall into that pile for me. I like businesses I can understand, it’s not even possible that the CEOs understand all that goes on within these large banks.

They are so incredibly complex and their balance sheets so huge and opaque that they are completely impossible to analyse. RBS at one stage had a balance sheet larger than the entire UK economy, talk about too big to fail! I also find the economics entirely underwhelming – let’s say a bank can achieve an ROE of 15%, which is in excess of where most banks are currently aiming for. Is that so impressive when you consider that they are leveraged somewhere between 10 and 50x!? That means their unlevered return is only 1.5% at most.

It is my personal opinion that banks on the whole are run not for shareholders or even for clients, but instead for employees. Banker remuneration is a much maligned topic but it’s perhaps most succinctly described by the old Wall Street book “Where Are the Customers Yachts?” I’d rather own businesses where my interests were better aligned with the staff.

Balance Sheets

The obsession with complicated ratios and “Stress Tests”! The most recent set of European Stress Tests modelled how banks would react in negative tail risk scenarios, however it failed to envision even the possibility of a Sovereign Default, that was deemed too stressful to be a reasonable assumption. This shows how fast things have deteriorated and how “Unstressful” Stress Tests are pointless. The other closely watched number is “Tier One Capital Ratio” – I barely understand what this even is despite my modicum of financial knowledge; what I DO know is that it doesn’t matter! Barclays, for example, are quite proud of their strong balance sheet and 11% Tier One Capital Ratio. Dexia had a Tier One Capital Ratio of 12% when it went bust last month. Go Figure! These figures mean nothing when nobody understands the assets on the balance sheet.

Banks have a nasty habit too – they are consistently profitable on the income statement, not that hard since all they have to do is borrow short from depositors and lend longer to businesses and mortgages. But unfortunately, these profits tend to lend to hubris at peaks in the business cycle which lead to an almost inevitable, although seldom as spectacular as 2008, blow up on the balance sheet. Some of their loan assets fail to be paid down and some of their bull market investments are shown to have been folly. There is a strong pattern of this repeating, profitable on the income statement and then a balance sheet blow up.

What Price Extreme Uncertainty?

In the current climate banks are a speculation on future economic, legal and political action or inaction. At the weekend, banks were forced to take a “voluntary” 50% haircut on their Greek Debt holdings (politely termed Private Sector Involvement!) so that it didn’t classify as a Credit Event to trigger CDS payouts. See video below for a reality check on the nonsense of this latest stop gap….

The problem with this latest sticking plaster for the EuroZone is that it will have multiple unintended consequences, which most likely won’t become apparent until they smack us in the face. If CDS payouts can now be adroitly circumvented at a political whim then what is the point of the market existing? We only buy insurance so that it pays out when the house burns down – what point if the contract is voided as you stand amongst the ashes?! There is a $62.2 TRILLION (read it twice to check!!) market in notional CDS globally. This is larger than the cumulative economic output of Planet Earth in any one year – there is now a huge question mark over the viability of this entire product.

1) Many CDS are used for legitimate hedging purposes rather than speculation. These legitimate corporate/pension/endowment hedgers will now be very fearful for their exposures – this will kill any animal spirits or willingness to take risk/proactive business decisions.

2) Remember all those banks and insurance companies who have been falling over themselves to tell investors and the press how they have “slashed European Sovereign Exposure”? Well….what’s the fastest way to do that? You certainly couldn’t liquidate all those bonds because there aren’t any buyers! You just bought CDS on the bonds and you’ll be fine in the “unlikely outcome that there is a credit event”. Uhoh, seems the Euro Leaders have decided that CDS “speculators” don’t deserve to be made whole despite them paying up front for a legally binding, arms length insurance contract between consenting parties. This means that all those banks who thought they had hedged their “Euro Problem” are infact just as naked and long as they were before.

As Ben Davies of Hinde Capital termed it, the EFSF has become the “European FUBAR Slush Fund”. (If you don’t know what FUBAR means then google it!)

Earnings Hocus Pocus

Banks have been reporting earnings this last week or so and there is a worrying trend. Circa 100% of earnings reported by Morgan Stanley and UBS and a further 60% of earnings reported by Barclays can be attributed to something which I would politely term an accounting “finesse”. Banks have embraced the option to use these so-called “Credit Valuation Adjustments” for the past 4 years, under the Financial Accounting Standards Board’s FAS 159 rule.

See below a few choice quotes from people far more insightful than I on the subject, plus my 2 cents where I feel it might add something….

“It’s worth observing that a number of banks reported positive “earnings surprises” last week. If you look at those results for any of the major banks, it is immediately clear that the bulk of the earnings were of two sources: further reductions in reserves against potential loan losses, and an accounting gain known as a “Credit Valuation Adjustment.” Those two items, for example, were responsible for nearly 90% of Citigroup’s reported “earnings.” The Credit Valuation Adjustment (CVA) works like this: as the bond market has become more concerned about new financial strains, the bonds of U.S. banks have sold off significantly in order to reflect higher default probabilities. Under U.S. accounting rules, bank assets are no longer marked to market, but happily for the banks, the decline in the market value of their bond liabilities means that the banks could technically “buy their bonds back cheaper.” So the decline in the bonds, despite being due to an increase in investor concerns about bank default, actually gets reported as an addition to earnings! Surprise, surprise.”

(John Hussman, 24 October, 2011)

This is scarily similar to the stories we heard in 2007/8 which were dismissed as fear-mongering. David Einhorn, manager of Greenlight Capital who was short Lehman Brothers all the way to zero and is recognized as an expert in sniffing out accounting shenanigans , pointed out……

“Lehman was taking advantage of a new accounting mechanism that allowed it to book revenue based on the declining value of its own debts. In other words, because of the increasingly risky state of Lehman, loans that other firms had made to Lehman had dropped in value, and under the new accounting, Lehman could count this as a gain. This is crazy accounting. I don’t know why they put it in. It means that the day before you go bankrupt is the most profitable day in the history of your company because you’ll say all the debt was worthless. You get to call it revenue. And literally they pay bonuses off this, which drives me nuts.”

So….the spike in CDS, the huge increase in the credit spread/risk premium demanded by investors to hold bank bonds is being used to prop up bank earnings! Bank Earnings will then go someway to deciding Bank Executive compensation! This is ludicrous.

I won’t claim that Richard Woolnough of M&G has been reading my recent emails, but he may as well have been…..

“In the more grown up world, this quarter’s banking results have been poor and are also dressed up. What’s lurking under the costume?

The oddest thing about this quarter’s bank results is how they turn bad into good by the method in which the banks account for bad news. The banks have for a number of quarters been applying the following make-up to their balance sheets. When their credit quality deteriorates, the value of their debt falls. This looks bad. It reflects their inability to finance and directly affects the future costs of the business when they come to refinance their debt. However, the banks are allowed to take this loss that has been suffered by their bond holders and book it as a profit. You therefore get the oddity that as the outlook for the bank deteriorates, its credit spreads widen, and it is able to book the spread widening on its own debt as a profit.

The banks and their auditors think this accounting use is sound. We, however, wonder how correct it is. Presumably, using their logic, the accountants and management of Lehman Brothers would argue that the quarter it went bust was its most profitable ever because its debt traded at and near to zero. In fact, that last quarter of trading could well have earned more for the company than its previous 100 plus years of existence. Trick or treat.”

What is going on!? Why are CVA’s still allowed? Will we never learn? What are shareholders going to do when more Rights Issues are required?

As I suggested at the start, I don’t think the Developed World Economies or their stock markets recover until we have resolved the many problems deep within our banking sector.

This post is an amalgam of various emails I penned over the course of July, August and September trying to provide hard evidence to support my belief that we are slipping into another recession in Q4 or Q1 2012 which unfortunately, will most likely be global in nature.
This is clearly not currently the consensus on The Street, although we have seen over the last quarter that global growth forecasts have been lowered and people are at least considering the possibility that it might happen. I’d like to contrast this with the beginning of 2011 when outlooks were MUCH rosier and people GENUINELY, in their heart of hearts, thought that we’d see rate interest rises in the developed world up to maybe 2%.
Many Sell-Side analysts are currently telling us that a recession is now already fully discounted in stock prices – I respectfully disagree. These are the same sell-side analysts who didn’t see even a remote recession risk just 6 months ago and the same guys who didn’t see a recession coming down the tracks in 2007 either.
Most value investors don’t pay much attention to the macro situation but I think they are missing a trick. Given that the average stock market decline during a recession is 40% it seems to me that an attempt to be “macro aware” is worth the effort!The Purpose of this Post is to encourage caution! Although much of what I post on this blog will be long equity ideas I do think that I should emphasise that I am not bullish on the broad indexes, infact I err bearishly! I usually hedge my longs with at least some degree of shorts on various indexes of my choice. These are not valuation levels at which I want to be naked long and the political/economic/monetary picture is so cloudy that I fear we must practice defensive investing. More Cash, Lower Net Exposure.

The Facts
I don’t particularly like this from M&G and David Rosenberg. I don’t like that it relies upon only ONE variable, but it works.
As you can see the blue line tends to lead the orange line, effectively the business “outlook” leads the actual output of the economy which makes intuitive sense. Businesses become more pessimistic and then reign in spending which has knock on effects throughout the supply chain. Only the instance in 2001 acts as an exception – when the economy didn’t quite slump along with business confidence.

Exhibit 2

This more complete analysis is lifted from the supremely insightful and diligent John Hussman – he has compiled what he calls a “Recession Warning Composite”….

“The components of our recession warning composite might be called “weak learners” in that none of them, individually, has a particularly notable record in anticipating recessions. The full syndrome of conditions, however, captures a critical “signature” of recessions. That signature of “early warning” conditions is based on financial market indicators including credit spreads, equity prices and yield curve behavior, coupled with slowing in measures of employment and business activity.Every historical instance of this full syndrome has been associated with an ongoing or immediately impending recession.”

The components are:1: Widening credit spreads: An increase over the past 6 months in either the spread between commercial paper and 3-month Treasury yields, or between the Dow Corporate Bond Index yield and 10-year Treasury yields.

2: Falling stock prices: S&P 500 below its level of 6 months earlier.

3: Weak ISM Purchasing Managers Index: PMI below 50, or3: (alternate): Moderating ISM and employment growth: PMI below 54, coupled with slowing employment growth: either total nonfarm employment growth below 1.3% over the preceding year (this is a figure that Marty Zweig noted in a Barron’s piece many years ago), or an unemployment rate up 0.4% or more from its 12-month low.

4: Moderate or flat yield curve: 10-year Treasury yield no more than 2.5% above 3-month Treasury yields if condition 3 is in effect, or any difference of less than 3.1%

Components 1, 2 and 4 are all obviously flashing RED for danger and we posted an August PMI of 50.6 for the US Economy! In addition, we have an unemployment rate that is starting to creep up again from already elevated levels. So as far as I’m concerned Criteria 3 has been met too. What that means is that EITHER this composite will be proven wrong and its 100% track record is ruined or we will enter another recession. Given the tepid nature of the data, the mess in Europe and the negative growth surprises in Asia, I fail to see where the US economy pulls the proverbial rabbit from.

Exhibit 3

Look at the video below with Lakshman Achuthan of the Economic Cycle Research Institute. As he points out he has no record of being wrong on this, his recession call track record is perfect. This video is a must watch.

“A broad range – this is not based on any one indicator – this is based on dozens of indicators for the United States – there is a contagion among those forward looking indicators that we only see at the onset of a business cycle recession.

A recession is a process, and I think a lot of people don’t understand that; they’re looking for two negative quarters of GDP. But it is a process where sales disappoint, so production falls, employment falls, income falls, and then sales fall. That vicious circle has started.”

Exhibit 4

Emerging Markets Are NOT going to Save Us

Remember that below 50 on the PMI means an economy that is contracting.

Here we are three years on from Lehman – 300 year low interest rates, mega stimulus, currency printing and competitive devaluation: Outcome – no more jobs, tepid growth, no housing recovery and bigger problems with bigger banks.

Globally economies are simultaneously swan-diving off a cliff and our collective faith in the fabled “policy response” is dwindling.

Exhibit 5

As I have been saying for MONTHS the big factor not being looked at is that Earnings Expectations are way, way too high and they are based upon the perpetuation of what are peak profit margins – there is a good chance that Q4 and Q1 2012 earnings seasons will be horrific.

If Analysts pull down earnings numbers, then all of a sudden the “market is cheap on forward earnings” crowd don’t have a leg to stand on. The first signs of this have been seen in the last few weeks – Eurozone Earnings Estimates off more than 10% but the US has barely budged. To exacerbate this further, Goldman Sachs made a loss and Apple missed on it’s earnings estimates! Apple has beaten estimates THIRTY consecutive quarters – that goes back more than 7 years!!! These are 2 of the market generals that have led the recovery.

As Jeremy Grantham said – “This is no Market for Young Men”, since 1982 the market has favoured participants who underestimate the true nature of every crisis (The Optimists!). In such an environment the “buy the dips” mentality has been conditioned – there is a strong possibility that this gets beaten out of them here.

Bonus Points for the few who read this far…..Mohammed El Erian sounds disctinctly bearish too…..

http://europe.pimco.com/EN/Insights/Pages/Why-Good-Companies-May-Get-Even-Cheaper-for-Awhile-.aspx
If there is a recession Equity Markets will decline – do not for a second think that a full blown recession is priced in, especially in the US at 19x CAPE for the S&P 500! Furthermore, if we see profit margins mean revert then the earnings will start to fall too meaning that the numerator and denominator are declining in tandem causing precipitous falls in many highly rated equities. The proverbial “Double Whammy”!

Exhibit 6

Looking at the chart below (credit John Hussman) we can see a standardized composite of Economic Activity metrics. The current reading on the composite has been lower than its present reading ONLY 10 times in the last 43 years – 7 of them during a recession, 1 immediately prior to the 2008 recession and 2 false signals. That’s an 80% chance that the economy is about to double dip.

Below is a Probability Table put together by John Hussman using a broad basket of economic indicators – it’s a bit messy but it’s message is clear! The probability of the US being either in a recession or on the cusp of one is north of 90%. If you look at the black lines contrasted against the blue – you can see again there are ZERO false positives when the model predicts a recession with such a high probability. Maybe this time is somehow different. I just think it’s a poor idea to ignore the data here.

Exhibit 7

As of the latest GDP report, corporate profits are now at the highest ratio to GDP in history. The chart below illustrates the danger in extrapolating current high profit margins into the future. The blue line presents the ratio of profits/GDP (left scale). The red line presents the annual growth of corporate profits over the following 5-year period, and the right scale is inverted. Higher profit margins are predictably related to weak subsequent earnings growth over time.

This dynamic is why profit margins have a clear negative correlation with subsequent 5-10 year returns. Profit margins are currently very high, they have a very reliable tendency to mean revert, high margins are always associated with poor future realised returns – why do investors continue to pretend this is not the case!?

To put it as simply as possible – IF the red line continues to track the blue line, as it has ALWAYS done, we are in for very poor/negative profit growth for equities!

To paraphrase Grantham, if high profit margins can persist indefinitely then capitalism is broken and we have bigger issues at hand. High profit margins should attract competitors to an industry which will over time erode margins down to more normal/average levels.

Exhibit 8

Unfortunately, we are just about “due” one. The last recession began in 2007, that’s 4 whole years ago. Most agree that we are in for an extended period of slow growth with high and sticky unemployment. What goes along with this “New Normal” deleveraging environment resulting from a credit crisis is volatile markets with a secular grinding lower of the market P/E multiple along with more frequent recessions a la Japan. Central Banks have no Policy Tools left to save us – they have fired the QE Bazooka and rates are already at the zero bound.